10-Q 1 agnc10q93011.htm FORM 10-Q AGNC 10Q 9/30/11


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________________________________ 
FORM 10-Q
 __________________________________________________
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-34057
__________________________________________________ 
AMERICAN CAPITAL AGENCY CORP.
(Exact name of registrant as specified in its charter)
__________________________________________________
Delaware
 
26-1701984
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
2 Bethesda Metro Center, 14th Floor
Bethesda, Maryland 20814
(Address of principal executive offices)
(301) 968-9300
(Registrant’s telephone number, including area code)
 __________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter earlier period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
ý
 
Accelerated filer
¨
 
 
 
 
 
Non-accelerated filer
¨
(Do not check if a smaller reporting company)
Smaller Reporting Company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of October 31, 2011 was 183,619,759
 



AMERICAN CAPITAL AGENCY CORP.
TABLE OF CONTENTS
 


1



PART I.—FINANCIAL INFORMATION

ITEM 1.
Financial Statements

AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
 
 
September 30, 2011
 
December 31, 2010
 
(Unaudited)
 
 
Assets:
 
 
 
Agency securities, at fair value (including pledged securities of $38,860,353 and $12,270,909, respectively)
$
41,970,419

 
$
13,510,280

U.S. Treasury securities, at fair value
300,873

 

Cash and cash equivalents
984,393

 
173,258

Restricted cash
375,207

 
76,094

Derivative assets, at fair value
54,532

 
76,593

Receivable for agency securities sold
2,698,121

 
258,984

Principal payments receivable
33,831

 
75,524

Receivable under reverse repurchase agreements
473,800

 
247,438

Other assets
148,253

 
57,658

Total assets
$
47,039,429

 
$
14,475,829

Liabilities:
 
 
 
Repurchase agreements
$
38,841,619

 
$
11,680,092

Other debt
56,864

 
72,927

Payable for agency securities purchased
1,660,276

 
727,374

Derivative liabilities, at fair value
792,714

 
78,590

Dividend payable
257,068

 
90,798

Obligation to return securities borrowed under reverse repurchase agreements, at fair value
473,247

 
245,532

Accounts payable and other accrued liabilities
17,385

 
8,452

Total liabilities
42,099,173

 
12,903,765

Stockholders’ equity:
 
 
 
Preferred stock, $0.01 par value; 10,000 shares authorized, 0 shares issued and outstanding, respectively

 

Common stock, $0.01 par value; 300,000 and 150,000 shares authorized, 183,620 and 64,856 shares issued and outstanding, respectively
1,836

 
649

Additional paid-in capital
4,829,065

 
1,561,908

Retained earnings
67,174

 
78,116

Accumulated other comprehensive income (loss)
42,181

 
(68,609
)
Total stockholders’ equity
4,940,256

 
1,572,064

Total liabilities and stockholders’ equity
$
47,039,429

 
$
14,475,829

See accompanying notes to consolidated financial statements.


2



AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
(Unaudited)
(in thousands, except per share data)
 
 
For the three months ended September 30,
 
For the nine months ended September 30,
 
2011
 
2010
 
2011
 
2010
Interest income:
 
 
 
 
 
 
 
Interest income
$
326,754

 
$
62,600

 
$
755,975

 
$
151,986

Interest expense
95,036

 
18,531

 
194,500

 
51,389

Net interest income
231,718

 
44,069

 
561,475

 
100,597

Other income, net:
 
 
 
 
 
 
 
Gain on sale of agency securities, net
262,768

 
24,565

 
360,880

 
81,558

Realized loss on periodic interest settlements of interest rate swaps, net
(1,773
)
 

 
(1,773
)
 

Other realized loss on derivative instruments and other securities, net
(173,190
)
 
(736
)
 
(222,594
)
 
(4,214
)
Unrealized loss on derivative instruments and other securities, net
(46,543
)
 
(2,997
)
 
(85,623
)
 
(15,466
)
Total other income, net
41,262

 
20,832

 
50,890

 
61,878

Expenses:
 
 
 
 
 
 
 
Management fees
15,634

 
2,697

 
36,511

 
6,795

General and administrative expenses
5,845

 
1,926

 
12,988

 
5,394

Total expenses
21,479

 
4,623

 
49,499

 
12,189

Income before tax
251,501

 
60,278

 
562,866

 
150,286

Excise tax
1,100

 
250

 
1,100

 
250

Net income
$
250,401

 
$
60,028

 
$
561,766

 
$
150,036

Net income per common share—basic and diluted
$
1.39

 
$
1.69

 
$
4.19

 
$
4.97

Weighted average number of common shares outstanding—basic and diluted
180,725

 
35,495

 
134,163

 
30,161

Dividends declared per common share
$
1.40

 
$
1.40

 
$
4.20

 
$
4.20

Comprehensive income:
 
 
 
 
 
 
 
Net income
$
250,401

 
$
60,028

 
$
561,766

 
$
150,036

Other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized gain on available-for-sale securities, net
535,439

 
11,660

 
814,536

 
73,077

Unrealized loss on derivative instruments, net
(512,208
)
 
(38,620
)
 
(703,747
)
 
(91,002
)
Other comprehensive income (loss)
23,231

 
(26,960
)
 
110,789

 
(17,925
)
Comprehensive income
$
273,632

 
$
33,068

 
$
672,555

 
$
132,111

See accompanying notes to consolidated financial statements.


3



AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in thousands)
 
 
Preferred Stock
 
Common Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
 
Shares
 
Amount
 
Shares
 
Amount
 
Balance, December 31, 2010

 
$

 
64,856

 
$
649

 
$
1,561,908

 
$
78,116

 
$
(68,609
)
 
$
1,572,064

Net income

 

 

 

 

 
133,543

 

 
133,543

Other comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized loss on available- for-sale securities, net

 

 

 

 

 

 
(39,802
)
 
(39,802
)
Unrealized gain on designated derivative instruments, net

 

 

 

 

 

 
61,126

 
61,126

Issuance of common stock

 

 
63,964

 
639

 
1,752,173

 

 

 
1,752,812

Issuance of restricted stock

 

 
9

 

 

 

 

 

Stock-based compensation

 

 

 

 
38

 

 

 
38

Common dividends declared

 

 

 

 

 
(135,280
)
 

 
(135,280
)
Balance, March 31, 2011 (Unaudited)

 

 
128,829

 
1,288

 
3,314,119

 
76,379

 
(47,285
)
 
3,344,501

Net income

 

 

 

 

 
177,822

 

 
177,822

Other comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized gain on available- for-sale securities, net

 

 

 

 

 

 
318,899

 
318,899

Unrealized loss on derivative instruments, net

 

 

 

 

 

 
(252,664
)
 
(252,664
)
Issuance of common stock

 

 
49,680

 
497

 
1,367,907

 

 

 
1,368,404

Stock-based compensation

 

 

 

 
44

 

 

 
44

Common dividends declared

 

 

 

 

 
(180,360
)
 

 
(180,360
)
Balance, June 30, 2011 (Unaudited)

 

 
178,509

 
1,785

 
4,682,070

 
73,841

 
18,950

 
4,776,646

Net income

 

 

 

 

 
250,401

 

 
250,401

Other comprehensive income (loss):


 


 


 


 


 


 


 


Unrealized gain on available- for-sale securities, net

 

 

 

 

 

 
535,439

 
535,439

Unrealized loss on derivative instruments, net

 

 

 

 

 

 
(512,208
)
 
(512,208
)
Issuance of common stock

 

 
5,108

 
51

 
146,949

 

 

 
147,000

Issuance of restricted stock

 

 
3

 

 

 

 

 

Stock-based compensation

 

 

 

 
46

 

 

 
46

Common dividends declared

 

 

 

 

 
(257,068
)
 

 
(257,068
)
Balance, September 30, 2011 (Unaudited)

 
$

 
183,620

 
$
1,836

 
$
4,829,065

 
$
67,174

 
$
42,181

 
$
4,940,256

See accompanying notes to consolidated financial statements.


4



AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
 
 
For the nine months ended September 30,
 
2011
 
2010
Operating activities:
 
 
 
Net income
$
561,766

 
$
150,036

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Amortization of agency securities premiums and discounts, net
239,508

 
65,953

Amortization of interest rate swap termination fee

 
6,278

Stock-based compensation
128

 
68

Gain on sale of agency securities, net
(360,880
)
 
(81,558
)
Loss on derivative instruments and other securities, net
309,990

 
19,680

Increase in other assets
(90,595
)
 
(19,457
)
Increase (decrease) in accounts payable and other accrued liabilities
8,933

 
(812
)
Net cash provided by operating activities
668,850

 
140,188

Investing activities:
 
 
 
Purchases of agency securities
(56,422,788
)
 
(12,301,251
)
Proceeds from sale of agency securities
24,351,207

 
6,693,342

Purchases of U.S. Treasury securities
(4,058,828
)
 
(465,149
)
Proceeds from sale of U.S. Treasury securities
3,791,498

 
466,775

Proceeds from U.S. Treasury securities sold, not yet purchased
12,053,954

 

Purchases of U.S. Treasury securities sold, not yet purchased
(11,918,676
)
 

Proceeds from reverse repurchase agreements
28,615,437

 

Payments made on reverse repurchase agreements
(28,841,942
)
 

Net payments on other derivative instruments not designated as qualifying hedges
(194,081
)
 
(14,092
)
Principal collections on agency securities
3,058,375

 
972,551

Net cash used in investing activities
(29,565,844
)
 
(4,647,824
)
Financing activities:
 
 
 
Cash dividends paid
(406,438
)
 
(118,638
)
Increase in restricted cash
(299,113
)
 
(42,834
)
Proceeds from repurchase arrangements, net
27,161,527

 
4,127,565

Proceeds from other debt

 
80,822

Repayments on other debt
(16,063
)
 

Net proceeds from common stock issuances
3,268,216

 
373,184

Net cash provided by financing activities
29,708,129

 
4,420,099

Net change in cash and cash equivalents
811,135

 
(87,537
)
Cash and cash equivalents at beginning of period
173,258

 
202,803

Cash and cash equivalents at end of period
$
984,393

 
$
115,266

See accompanying notes to consolidated financial statements.


5



AMERICAN CAPITAL AGENCY CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Note 1. Unaudited Interim Consolidated Financial Statements
The interim consolidated financial statements of American Capital Agency Corp. (referred throughout this report as the “Company”, “we”, “us” and “our”) are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates.
Our unaudited consolidated financial statements include the accounts of our wholly-owned subsidiary, American Capital Agency TRS, LLC, and variable interest entities for which the Company is the primary beneficiary. Significant intercompany accounts and transactions have been eliminated. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, necessary for the fair presentation of financial statements for the interim period have been included. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year.

Note 2. Organization
We were organized in Delaware on January 7, 2008, and commenced operations on May 20, 2008 following the completion of our initial public offering (“IPO”). Our common stock is traded on The NASDAQ Global Select Market under the symbol “AGNC”.
We have elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). As such, we are required to distribute annually 90% of our taxable net income. As long as we qualify as a REIT, we will generally not be subject to U.S. federal or state corporate taxes on our taxable net income to the extent that we distribute all of our annual taxable net income to our stockholders. It is our intention to distribute 100% of our taxable income, after application of available tax attributes, within the limits prescribed by the Code, which may extend into the subsequent taxable year.
We are externally managed by American Capital AGNC Management, LLC (our “Manager”), an affiliate of American Capital, Ltd. (“American Capital”).
We earn income primarily from investing in residential mortgage pass-through securities and collateralized mortgage obligations (“CMOs”) on a leveraged basis. These investments consist of securities for which the principal and interest payments are guaranteed by government-sponsored entities (“GSEs”), such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as the Government National Mortgage Association (“Ginnie Mae”). We refer to these types of securities as agency securities and the specific agency securities in which we invest as our investment portfolio.
Our principal objective is to preserve our net asset value (also referred to as stockholders' equity) while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends from the combination of our net interest income and net realized gains and losses on our investments and other hedging activities. Our net interest income consists of the spread between the interest income earned on our agency securities and the interest costs of our borrowings and derivatives accounted for as hedges for accounting purposes (refer to Note 3 regarding discontinuation of hedge accounting as of September 30, 2011). We fund our investments primarily through short-term borrowings structured as repurchase agreements.

Note 3. Summary of Significant Accounting Policies
Investments in Agency Securities
Accounting Standards Codification (“ASC”) Topic 320, Investments—Debt and Equity Securities (“ASC 320”), requires that at the time of purchase, we designate a security as held-to-maturity, available-for-sale or trading, depending on our ability and intent to hold such security to maturity. Securities classified as trading and available-for-sale are reported at fair value, while securities classified as held-to-maturity are reported at amortized cost. We may, from time to time, sell any of our agency securities as part of our overall management of our investment portfolio. Accordingly, we typically designate our agency securities as available-for-sale. All securities classified as available-for-sale are reported at fair value, with unrealized gains and

6



losses reported in other comprehensive income (loss) (“OCI”), a component of stockholders’ equity. Upon the sale of a security, we determine the cost of the security and the amount of unrealized gains or losses to reclassify out of accumulated OCI into earnings based on the specific identification method.
Interest-only securities and inverse interest-only securities (collectively referred to as “interest-only securities”) represent our right to receive a specified proportion of the contractual interest flows of specific agency and CMO securities. Principal-only securities represent our right to receive the contractual principal flows of specific agency and CMO securities. Interest-only and principal-only securities are measured at fair value through earnings in unrealized gain (loss) on derivative instruments and other securities, net in our consolidated statements of operations and comprehensive income. Our investments in interest-only and principal-only securities are included in agency securities, at fair value on the accompanying consolidated balance sheets.
We estimate the fair value of our agency securities based on a market approach using Level 2 inputs from third-party pricing services and dealer quotes. The third-party pricing services use pricing models that incorporate such factors as coupons, primary and secondary mortgage rates, prepayment speeds, spread to the Treasury and interest rate swap curves, convexity, duration, periodic and life caps and credit enhancements. The dealer quotes incorporate common market pricing methods, including a spread measurement to the Treasury or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security.
We evaluate securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Based on the criteria in ASC 320, the determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. When an agency security is impaired, an OTTI is considered to have occurred if (i) we intend to sell the agency security (i.e. a decision has been made as the reporting date) or (ii) it is more likely than not that we will be required to sell the agency security before recovery of its amortized cost basis. If we intend to sell the security or if it is more likely than not that we will be required to sell the agency security before recovery of its amortized cost basis, the entire amount of the impairment loss, if any, is recognized in earnings as a realized loss and the cost basis of the security is adjusted to its fair value.
We did not recognize any OTTI charges on any of our agency securities for the nine months ended September 30, 2011 and 2010.
Interest Income
Interest income is accrued based on the outstanding principal amount of the agency securities and their contractual terms. Premiums and discounts associated with the purchase of agency securities are amortized or accreted into interest income over the projected lives of the securities, including contractual payments and estimated prepayments using the interest method in accordance with ASC Subtopic 310-20, Receivables—Nonrefundable Fees and Other Costs (“ASC 310-20”).
We estimate long-term prepayment speeds using a third-party service and market data. The third-party service estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, current mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the reasonableness of the prepayment speeds estimated by the third-party service and based on our Manager’s judgment we may make adjustments to their estimates. Actual and anticipated prepayment experience is reviewed quarterly and effective yields are recalculated when differences arise between the previously estimated future prepayments and the amounts actually received plus current anticipated future prepayments. If the actual and anticipated future prepayment experience differs from our prior estimate of prepayments, we are required to record an adjustment in the current period to the amortization or accretion of premiums and discounts for the cumulative difference in the effective yield through the reporting date.
In addition, pursuant to ASC 310-20, the yield on our adjustable rate securities assumes that the securities reset at a rate equal to the underlying index rate in effect as of the date we acquired the security plus the stated margin. Consequently, future reset rate assumptions incorporated in our asset yields may differ materially from future reset rates implied by the forward yield curve and the actual reset rates ultimately achieved. Further, notwithstanding changes to our actual and projected constant prepayment rate (“CPR”) assumptions, the lower our reset rate assumption is pursuant to ASC 310-20 than the current fixed rate in effect, the greater the rate of premium amortization we will recognize over the initial fixed rate period.
Our adjustable rate portfolio was acquired for a premium above par value and most securities were acquired during a period of historically low index rates. Accordingly, the premium balance on our adjustable rate securities will generally be fully amortized prior to their first reset date, regardless of actual or forecasted prepayment speeds and changes in the underlying

7



index rates prior to actual reset. Adjustable rate securities acquired during a different interest rate environment may experience a different premium amortization pattern even as current index rates remain near their historical lows.
Derivative and other Hedging Instruments
We maintain a risk management strategy, under which we use a variety of strategies to hedge some of our exposure to interest rate risk. The objective of our risk management strategy is to reduce fluctuations in book value over a range of interest rate scenarios. In particular, we attempt to mitigate the risk of the cost of our variable rate liabilities increasing during a period of rising interest rates. The principal instruments that we use are interest rate swaps and options to enter into interest rate swaps (“interest rate swaptions”). We also purchase or sell to-be-announced forward contracts (“TBAs”), specified agency securities on a forward basis, U.S. Treasury securities and U.S. Treasury futures contracts, purchase or write put or call options on TBA securities and invest in other types of mortgage derivatives, such as interest-only securities, and synthetic total return swaps, such as the Markit IOS Synthetic Total Return Swap Index (“Markit IOS Index”).
We account for derivative instruments in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”). ASC 815 requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value. Hedging instruments that are not derivatives under ASC 815 are accounted for as securities in accordance with ASC 320.
The accounting for changes in the fair value of derivative instruments depends on whether we have designated them as hedging instruments and whether they qualify as part of a hedging relationship pursuant to ASC 815 and, if so, on our reason for holding them.
Derivatives that are intended to hedge exposure to variability in expected future cash flows are referred to as cash flow hedges. For derivatives designated in qualifying cash flow hedge relationships, the effective portion of the fair value adjustments is initially recorded in OCI (a component of stockholders’ equity) and reclassified to income at the time that the hedged transactions affect earnings. The ineffective portion of the fair value adjustments is immediately recognized in unrealized gain (loss) on derivative instruments and other securities, net. When the underlying hedged transaction ceases to exist, any amounts that have been previously recorded in accumulated OCI would be reclassified to net income and all subsequent changes in the fair value of the instrument would be included in unrealized gain (loss) on derivative instruments and other securities, net for each period until the derivative instrument matures or is settled.
For example, in the case of interest rate swap agreements in designated qualifying cash flow hedge relationships ("designated interest rate swaps"), the effective portion of changes in the fair value of the designated interest rate swaps are recorded in OCI. Accumulated OCI is subsequently reclassified into earnings through interest expense as the underlying repurchase agreements (hedged transactions) incur interest. The ineffective portion of fair value adjustments of designated interest rate swaps primarily relates to timing mismatches between the monthly variable rate reset dates of the interest rate swaps and the term of the underlying repurchase agreements. The underlying hedged transactions are determined to cease to exist for designated interest rate swap agreements (or previously designated interest rates swaps discussed below), if the current (or anticipated) repurchase agreement balance is less than the current notional value of the interest rate swap agreements.
For derivatives not designated in hedging relationships under ASC 815, the fair value adjustments are recorded in unrealized gain (loss) on derivative instruments and other securities, net. Our net book value is the same irrespective of whether we designate a derivative as a qualifying cash flow hedge.
Derivatives in a gain position are reported as derivative assets at fair value and derivatives in a loss position are reported as derivative liabilities at fair value in our consolidated balance sheets. In our consolidated statements of cash flows, cash receipts and payments related to derivative instruments are classified according to the underlying nature or purpose of the derivative transaction, generally in the operating section for derivatives designated in hedging relationships and the investing section for derivatives not designated in hedging relationships.
The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings and monitoring positions with individual counterparties. In addition, we mark our net counterparty exposure to market on a daily basis and adjust posted collateral (in either direction) as a result.
Interest rate swap agreements
We use interest rate swaps to hedge the variable cash flows associated with short-term borrowings made under our repurchase agreement facilities. Prior to the quarter ended September 30, 2011, we generally entered into such derivatives with the intention of qualifying for hedge accounting under ASC 815.

8



During the quarter ended September 30, 2011, we discontinued our election to account for interest rate swaps as designated cash flow hedges. In order for our interest rate swaps to qualify as cash flow hedges under ASC 815, the monthly reset dates of our interest rate swaps are required to align with the term of an underlying repurchase agreement. This alignment had the effect of limiting our ability to alter or extend the maturity of our repurchase agreements. To provide greater funding flexibility, we determined that it was not beneficial to always match the pricing dates of our swaps and repurchase agreements and, thus, elected to discontinue hedge accounting by a combination of not designating new interest rate swaps entered into as qualifying cash flow hedges and de-designating all of our remaining swap contracts on September 30, 2011.
Provided we continue to hold repurchase agreements in excess of the notional value of our de-designated swap contracts, the net deferred loss related to the discontinued hedges incurred prior to de-designation will continue to be reported in accumulated OCI and will be reclassified into earnings through interest expense on a straight-line basis over their remaining contractual term, similar to as if the interest rate swaps had not been de-designated. As of September 30, 2011, the net deferred loss related to these interest rate swaps was $744.4 million and their weighted average remaining contractual term was 3.4 years. The net deferred loss expected to be reclassified from OCI into interest expense over the next twelve months is $208.8 million. In addition, all subsequent changes in the fair value of interest rates swaps will be recognized in our consolidated statement of operations and comprehensive income in unrealized gain (loss) on derivative instruments and other securities, net. Further, starting October 1, 2011, the net interest paid or received on our de-designated interest rate swaps, less amounts reclassified from accumulated OCI into earnings through interest expense, will be recognized in realized gain (loss) on periodic interest settlements of interest rate swaps, net. The net interest paid or received on our un-designated interest rate swaps is currently recognized in our consolidated statement of operations and comprehensive income in realized gain (loss) on periodic interest settlements of interest rate swaps, net.
We estimate the fair value of interest rate swaps based on inputs from a third-party pricing model. The third-party pricing model incorporates such factors as the Treasury curve, LIBOR rates, and the pay rate on the interest rate swaps. We also incorporate both our own and our counterparties’ nonperformance risk in estimating the fair value of our interest rate swap and swaption agreements. In considering the effect of nonperformance risk, we consider the impact of netting and credit enhancements, such as collateral postings and guarantees, and have concluded that our own and our counterparty risk is not significant to the overall valuation of these agreements.
Interest rate swaptions
We may purchase interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the performance of our investment portfolio (referred to as “convexity risk”). The interest rate swaptions provide us the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as an asset in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the swaption is reported in unrealized gain (loss) on derivative instruments and other securities, net in our consolidated statement of operations and comprehensive income. If a swaption expires unexercised, the loss on the swaption would be equal to the premium paid. If we sell or exercise a swaption, the realized gain or loss on the swaption would be equal to the difference between the cash or the fair value of the underlying interest rate swap received and the premium paid.
We estimate the fair value of interest rate swaptions based on the fair value of the future interest rate swap that we have the option to enter into as well as the remaining length of time that we have to exercise the option.
TBA securities
A TBA security is a futures contract for the purchase or sale of agency securities at a predetermined price, face amount, issuer, coupon and stated maturity on an agreed-upon future date. The specific agency securities delivered into the contract upon the settlement date, published each month by the Securities Industry and Financial Markets Association, are not known at the time of the transaction. TBA securities are exempt from ASC 815 and are accounted for under ASC 320 if there is no other way to purchase or sell that security, if delivery of that security and settlement will occur within the shortest period possible for that type of security and if it is probable at inception and throughout the term of the individual contract that physical delivery of the security will occur (referred to as the “regular-way” exception). Alternatively, we may designate the TBA security as a qualifying cash flow hedge under ASC 815 if the regular-way exception is not met and at the time of the purchase or sale of the security, and throughout the term of the individual contract, it is probable that the forecasted transaction will occur and the hedging relationship is expected to be highly effective. For TBA security contracts that we have entered into, we have generally not asserted that physical settlement is probable or that the forecasted transaction is probable of occurring and, therefore, we typically have not designated these forward commitments as hedging instruments. Realized and unrealized gains and losses associated with TBA contracts not subject to the regular-way exception or not designated as hedging instruments are recognized in our consolidated statement of operations and comprehensive income in other realized gain (loss) on derivative instruments

9



and other securities, net and unrealized gain (loss) on derivative instruments and other securities, net, respectively.
We estimate the fair value of TBA securities based on similar methods used to value agency securities.
Put and call options on TBA securities
We may purchase put and call options on TBA securities to hedge against short-term changes in interest rates. Under a purchased put option, we have the right to sell to the counterparty a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. Under a purchased call option, we have the right to purchase from the counterparty a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. The premium paid for a put or call option is reported as an asset in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the option that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the option is reported in gain (loss) on derivative instruments and other securities, net in our consolidated statement of operations and comprehensive income. When a purchased put or call option expires unexercised, a realized loss is reported in our consolidated statement of operations and comprehensive income equal to the premium paid. When a purchased put or call option is exercised, a realized gain or loss is reported in our consolidated statement of operations and comprehensive income equal to the difference between the premium paid and the fair value of the exercised put or call option. In addition, a derivative asset is recorded in our consolidated balance sheet for the TBA security resulting from the put or call option exercise.
We may also write put and call options on TBA securities. Under a written put option, the counterparty has the right to sell us a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. Under a written call option, the counterparty has the right to purchase from us a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. The premium received from writing a put or call option is reported as a liability in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the option that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the option is reported in gain (loss) on derivative instruments and other securities, net in our consolidated statement of operations and comprehensive income. When a written put or call option expires unexercised, a realized gain is reported in our consolidated statement of operations equal to the premium received. When we terminate a written put or call option, a realized gain or loss is reported in our consolidated statement of operations equal to the difference between the termination payment and the premium received. When a written put or call option is exercised, a realized gain or loss is reported in our consolidated statement of operations equal to the difference between the premium received and the fair value of the exercised put or call option. In addition, a derivative asset or liability is recorded in our consolidated balance sheet for the TBA security resulting from the put or call option exercise.
We estimate the fair value of put and call options on TBA securities based on the fair value of the underlying TBA security as well as the remaining length of time to exercise the option.

Forward commitments to purchase or sell specified agency securities
We may enter into a forward commitment to purchase or sell specified agency securities as a means of acquiring assets or as a hedge against short-term changes in interest rates. Contracts for the purchase or sale of specified agency securities are accounted for as derivatives if the delivery of the specified agency security and settlement extends beyond the shortest period possible for that type of security. We may designate the forward commitment as a qualifying cash flow hedge if at the time of the purchase or sale of the security, and throughout the term of the individual contract, it is probable that physical delivery of the security will occur. Realized and unrealized gains and losses associated with forward commitments not designated as hedging instruments are recognized in our consolidated statement of operations and comprehensive income in gain (loss) on derivative instruments and other securities, net.
We estimate the fair value of forward commitments to purchase or sell specified agency securities based on similar methods used to value agency securities as well as the remaining length of time of the forward commitment.
U.S. Treasury securities
We may purchase or sell short U.S. Treasury securities and U.S. Treasury futures contracts to help mitigate the potential impact of changes in interest rates on the performance of our portfolio. We may borrow securities to cover short sales of U.S. Treasury securities under reverse repurchase agreements. We account for these as securities borrowing transactions and recognize an obligation to return the borrowed securities at fair value on the balance sheet based on the value of the underlying borrowed securities as of the reporting date. Realized and unrealized gains and losses associated with purchases and short sales of U.S. Treasury securities are recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statements of operations and comprehensive income.

10



Total return swaps
We may enter into total return swaps to obtain exposure to a security or market sector without owning such security or investing directly in that market sector. Total return swaps are agreements in which there is an exchange of cash flows whereby one party commits to make payments based on the total return (coupon plus the mark-to-market movement) of an underlying instrument or index in exchange for fixed or floating rate interest payments. To the extent the total return of the instrument or index underlying the transaction exceeds or falls short of the offsetting interest rate obligation, we will receive a payment from or make a payment to the counterparty.
The primary total return swap index in which we invest is the Markit IOS Index. Total return swaps based on the Markit IOS index are intended to synthetically replicate the performance of interest-only securities. We determine the fair value of our total return swaps based on published index prices. Realized and unrealized gains and losses associated with changes in market value of the underlying index and coupon interest are recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statements of operations and comprehensive income.
Variable Interest Entities
ASC Topic 810, Consolidation (“ASC 810”), requires a qualitative assessment in determining the primary beneficiary of a variable interest entities (“VIEs”) and ongoing assessments of control over such entities as well as additional disclosures for entities that have variable interests in VIEs.
We may enter into transactions involving a CMO trust (e.g. a VIE) whereby we transfer agency securities to an investment bank in exchange for cash proceeds and at the same time enter into a commitment with the same investment bank to purchase to-be-issued securities collateralized by the agency securities transferred. We will consolidate a CMO trust (as it relates to the assets transferred or contributed by us and the related liabilities issued by the trust) if we are the CMO trust’s primary beneficiary; that is, if we have a variable interest (or combination of variable interests) that provides us with a controlling financial interest in the CMO trust. An entity is deemed to have a controlling financial interest if the entity has the power to direct the activities of a VIE that most significantly impacts the VIE’s economic performance and the obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE. In determining if we have a controlling financial interest, we evaluate whether we share the power to control the selection of financial assets transferred to the CMO trust with an unrelated party. We may share power in the selection of assets for certain CMO trusts (i.e., both we and the unrelated party must consent to the transfer of such assets to the CMO trust); however, if our economic interest in the CMO trust is disproportionate to the shared power, we may be deemed to be the primary beneficiary.
Recent Accounting Pronouncements
In April 2011, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements (“ASU 2011-03”), which is intended to improve the accounting for repurchase agreements by removing from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, as well as implementation guidance related to that criterion. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011 and the guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. We do not believe the adoption of ASU 2011-03 will have a material impact on our consolidated financial statements.
In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”), which largely aligns fair value measurement and disclosure requirements between International Financial Reporting Standards and US GAAP. For US GAAP, the update mainly represents clarifications to Topic 820 as well as some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. ASU 2011-04 clarifies that (i) the highest and best use concept only applies to non-financial assets, (ii) an instrument classified in shareholders’ equity should be measured from the perspective of a market participant holding that instrument as an asset and (iii) quantitative disclosure is required for unobservable inputs used in Level 3 measurements. ASU 2011-04 also changes the guidance in Topic 820 so that (i) the fair value of a group of financial assets and financial liabilities with similar risk exposures may be measured on the basis of the entity’s net risk exposure, (ii) premiums or discounts may be applied in a fair value measurement under certain circumstances, but blockage factors are not permitted, and (iii) additional Level 3 disclosures are required, including a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. We do not believe the adoption of ASU 2011-04 will have a material impact on our consolidated financial statements.
In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive

11



Income(“ASU 2011-05”), which is intended to make the presentation of items within OCI more prominent. ASU 2011-05 requires companies to present comprehensive income in either one continuous statement or two separate but consecutive financial statements. Upon the effectiveness of ASU 2011-05, companies will no longer be allowed to present OCI in the statement of stockholders’ equity. In addition, reclassification adjustments between OCI and net income must be presented separately on the face of the financial statements. The new guidance does not change the components of OCI or the calculation of earnings per share. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted and the amendments should be applied retrospectively. We do not believe the adoption of ASU 2011-05 will have a material impact on our consolidated financial statements.
Reclassifications
Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period presentation.

Note 4. Agency Securities
The following tables summarize our investments in agency securities as of September 30, 2011 (dollars in thousands):
 
 
As of September 30, 2011
 
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Available-for-sale securities:
 
 
 
 
 
 
 
Agency securities, par
$
22,477,679

 
$
16,695,524

 
$
102,938

 
$
39,276,141

Unamortized discount
(914
)
 
(996
)
 

 
(1,910
)
Unamortized premium
988,626

 
709,012

 
3,743

 
1,701,381

Amortized cost
23,465,391

 
17,403,540

 
106,681

 
40,975,612

Gross unrealized gains
466,275

 
337,846

 
2,130

 
806,251

Gross unrealized losses
(11,342
)
 
(8,305
)
 
(23
)
 
(19,670
)
Available-for-sale securities, at fair value
23,920,324

 
17,733,081

 
108,788

 
41,762,193

Agency securities remeasured at fair value through earnings:
 
 
 
 
 
 
 
Interest-only and principal-only securities, amortized cost(1)
157,011

 
71,285

 

 
228,296

Gross unrealized gains
4,542

 
2,323

 

 
6,865

Gross unrealized losses
(14,086
)
 
(12,849
)
 

 
(26,935
)
Agency securities remeasured at fair value through earnings, at fair value
147,467

 
60,759

 

 
208,226

Total agency securities, at fair value
$
24,067,791

 
$
17,793,840

 
$
108,788

 
$
41,970,419

Weighted average coupon as of September 30, 2011(2)
4.38
%
 
4.31
%
 
4.15
%
 
4.35
%
Weighted average yield as of September 30, 2011(3)
3.17
%
 
3.20
%
 
2.17
%
 
3.18
%
Weighted average yield for the three months ended September 30, 2011(3)
3.14
%
 
3.12
%
 
2.22
%
 
3.14
%
Weighted average yield for the nine months ended September 30, 2011(3)
3.29
%
 
3.21
%
 
2.12
%
 
3.25
%
 ________________________
(1)
Interest-only securities represent the right to receive a specified portion of the contractual interest flows of the underlying unamortized principal balance (“UPB” or “par value”) of specific CMO securities. Principal-only securities represent the right to receive contractual principal flows of the UPB of specific CMO securities. The UPB of our interest-only securities was $1.3 billion and the weighted average contractual interest we are entitled to receive was 5.57% of this amount as of September 30, 2011. The UPB of our principal-only securities was $43 million as of September 30, 2011.
(2)
The weighted average coupon includes the interest cash flows from our interest-only securities taken together with the interest cash flows from our fixed-rate, adjustable-rate and CMO securities as a percentage of the par value of our agency securities (excluding the UPB of our interest-only securities) as of September 30, 2011.
(3)
Incorporates an average future constant prepayment rate assumption of 13% based on forward rates as of September 30, 2011 and an average reset rate for adjustable rate securities of 2.76%, which is equal to the average underlying index rate of 0.96% based on the current spot rate in effect as of the date we acquired the securities and an average margin of 1.80%.


12



 
As of September 30, 2011
 
Amortized
Cost
 
Gross
Unrealized
Gain
 
Gross
Unrealized
Loss
 
Fair Value
Fixed-Rate
$
37,554,811

 
$
741,800

 
$
(18,354
)
 
$
38,278,257

Adjustable-Rate
3,179,456

 
59,639

 
(1,316
)
 
3,237,779

CMO
241,345

 
4,812

 

 
246,157

Interest-only and principal-only securities
228,296

 
6,865

 
(26,935
)
 
208,226

Total agency securities
$
41,203,908

 
$
813,116

 
$
(46,605
)
 
$
41,970,419



The following tables summarize our investments in agency securities as of December 31, 2010 (dollars in thousands):
 
 
As of December 31, 2010
 
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Agency securities classified as available-for-sale:
 
 
 
 
 
 
 
Agency securities, par
$
8,207,464

 
$
4,599,712

 
$
100,408

 
$
12,907,584

Unamortized discount
(930
)
 
(1,044
)
 

 
(1,974
)
Unamortized premium
350,747

 
220,465

 
4,670

 
575,882

Amortized cost
8,557,281

 
4,819,133

 
105,078

 
13,481,492

Gross unrealized gains
56,181

 
11,929

 
384

 
68,494

Gross unrealized losses
(53,893
)
 
(42,356
)
 
(196
)
 
(96,445
)
Available-for-sale securities, at fair value
8,559,569

 
4,788,706

 
105,266

 
13,453,541

Agency securities remeasured at fair value through earnings:
 
 
 
 
 
 
 
Interest-only securities, amortized cost(1)
18,957

 
33,447

 

 
52,404

Gross unrealized gains
1,559

 
3,356

 

 
4,915

Gross unrealized losses
(91
)
 
(489
)
 

 
(580
)
Agency securities remeasured at fair value through earnings, at fair value
20,425

 
36,314

 

 
56,739

Total agency securities, at fair value
$
8,579,994

 
$
4,825,020

 
$
105,266

 
$
13,510,280

Weighted average coupon as of December 31, 2010(2)
4.63
%
 
4.83
%
 
4.37
%
 
4.70
%
Weighted average yield as of December 31, 2010(3)
3.34
%
 
3.28
%
 
2.14
%
 
3.31
%
Weighted average yield for the year ended December 31, 2010(3)
3.49
%
 
3.42
%
 
2.22
%
 
3.44
%
 ________________________
(1)
Interest-only securities represent the right to receive a specified portion of the contractual interest flows of the UPB of specific CMO securities. The UPB of our interest-only securities was $0.5 billion and the weighted average contractual interest we are entitled to receive was 4.95% of this amount as of December 31, 2010.
(2)
The weighted average coupon includes the interest cash flows from our interest-only securities taken together with the interest cash flows from our fixed-rate, adjustable-rate and CMO securities as a percentage of the par value of our agency securities (excluding the UPB of our interest-only securities) as of December 31, 2010.
(3)
Incorporates an average future constant prepayment rate assumption of 12% based on forward rates as of December 31, 2010 and an average reset rate for adjustable rate securities of 2.76%, which is equal to the average underlying index rate of 0.94% based on the current spot rate in effect as of the date we acquired the securities and an average margin of 1.82%.


13



 
As of December 31, 2010
 
Amortized
Cost
 
Gross
Unrealized
Gain
 
Gross
Unrealized
Loss
 
Fair Value
Fixed-Rate
$
9,144,352

 
$
39,844

 
$
(82,717
)
 
$
9,101,479

Adjustable-Rate
3,942,937

 
20,955

 
(13,728
)
 
3,950,164

CMO
394,203

 
7,695

 

 
401,898

Interest-only securities
52,404

 
4,915

 
(580
)
 
56,739

Total agency securities
$
13,533,896

 
$
73,409

 
$
(97,025
)
 
$
13,510,280


Actual maturities of agency securities are generally shorter than the stated contractual maturities. Actual maturities are affected by the contractual lives of the underlying mortgages, periodic principal payments and principal prepayments. The following table summarizes our agency securities classified as available-for-sale as of September 30, 2011 and December 31, 2010, according to their estimated weighted average life classification (dollars in thousands):
 
 
As of September 30, 2011
 
As of December 31, 2010
Estimated Weighted Average Life of Agency Securities Classified as
Available-for-Sale
 
Fair Value
 
Amortized
Cost
 
Weighted
Average
Coupon
 
Fair Value
 
Amortized
Cost
 
Weighted
Average
Coupon
Less than or equal to one year
 
$
3,097

 
$
3,112

 
5.50
%
 
$

 
$

 
%
Greater than one year and less than or equal to three years
 
7,769,007

 
7,613,464

 
4.32
%
 
133,123

 
132,520

 
5.05
%
Greater than three years and less than or equal to five years
 
30,555,145

 
29,971,368

 
4.09
%
 
3,841,282

 
3,821,992

 
4.92
%
Greater than five years
 
3,434,944

 
3,387,668

 
4.43
%
 
9,479,136

 
9,526,980

 
4.31
%
Total
 
$
41,762,193

 
$
40,975,612

 
4.16
%
 
$
13,453,541

 
$
13,481,492

 
4.49
%

The weighted average life of our interest-only securities was 2.8 and 6.2 years as of September 30, 2011 and December 31, 2010, respectively. The weighted average life of our principal-only securities was 2.4 years as of September 30, 2011. We did not have principal-only securities as of December 31, 2010.
The weighted average lives of the agency securities as of September 30, 2011 and December 31, 2010 incorporates anticipated future prepayment assumptions. As of September 30, 2011, our weighted average expected constant prepayment rate (“CPR”) over the remaining life of our aggregate investment portfolio is 13%. Our estimates differ materially for different types of securities and thus individual holdings have a wide range of projected CPRs. We estimate long-term prepayment assumptions for different securities using third-party services and market data. These third-party services estimate prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the prepayment speeds estimated by the third-party services and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate reasonableness. As market conditions may change rapidly, we use our judgment in making adjustments for different securities. Various market participants could use materially different assumptions.
Our agency securities classified as available-for-sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported in OCI, a component of stockholders’ equity. The following table summarizes changes in accumulated OCI for available-for-sale securities for the three and nine months ended September 30, 2011 and 2010 (in thousands): 
Agency Securities Classified as
Available-for-Sale
 
Beginning OCI
Balance
 
Unrealized Gains
and (Losses), Net
 
Reversal of Prior
Period Unrealized
(Gains) and Losses,
Net on Realization
 
Ending OCI
Balance
Three months ended September 30, 2011
 
$
251,151

 
801,694

 
(266,264
)
 
$
786,581

Three months ended September 30, 2010
 
$
97,435

 
37,461

 
(25,800
)
 
$
109,096

Nine months ended September 30, 2011
 
$
(27,950
)
 
1,178,365

 
(363,834
)
 
$
786,581

Nine months ended September 30, 2010
 
$
36,018

 
155,349

 
(82,271
)
 
$
109,096




14



The following table presents the gross unrealized loss and fair values of our available-for-sale agency securities by length of time that such securities have been in a continuous unrealized loss position as of September 30, 2011 and December 31, 2010 (in thousands):
 
 
 
Unrealized Loss Position For
 
 
Less than 12 Months
 
12 Months or More
 
Total
Agency Securities Classified as
Available-for-Sale
 
Estimated Fair
Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated Fair
Value
 
Unrealized
Loss
September 30, 2011
 
$
4,145,531

 
$
(19,670
)
 
$

 
$

 
$
4,145,531

 
$
(19,670
)
December 31, 2010
 
$
7,498,384

 
$
(96,445
)
 
$

 
$

 
$
7,498,384

 
$
(96,445
)

As of September 30, 2011, we did not intend to sell any of these agency securities and we believe it is not more likely than not we will be required to sell the agency securities before recovery of their amortized cost basis. The unrealized losses on these agency securities are not due to credit losses given the government-sponsored entity or government guarantees but are rather due to changes in interest rates and prepayment expectations.
Gains and Losses
The following table is a summary of our net gain from the sale of agency securities for the three and nine months ended September 30, 2011 and 2010 (in thousands): 
 
Three Months Ended
 
Nine Months Ended
 
September 30, 2011
 
September 30, 2010
 
September 30, 2011
 
September 30, 2010
Agency securities sold, at cost
$
(14,045,636
)
 
$
(2,172,978
)
 
$
(26,429,464
)
 
$
(6,914,764
)
Proceeds from agency securities sold(1)
14,308,404

 
2,197,543

 
26,790,344

 
6,996,322

Net gains on sale of agency securities
$
262,768

 
$
24,565

 
$
360,880

 
$
81,558

Gross gains on sale of agency securities
$
267,573

 
$
26,333

 
$
376,806

 
$
87,714

Gross losses on sale of agency securities
(4,805
)
 
(1,768
)
 
(15,926
)
 
(6,156
)
Net gains on sale of agency securities
$
262,768

 
$
24,565

 
$
360,880

 
$
81,558

  ________________________
(1)
Proceeds include cash received during the period, plus receivable for agency securities sold during the period as of period end.

For the three and nine months ended September 30, 2011, we recognized an unrealized loss of $27.5 and $24.4 million, respectively, and for the three and nine months ended September 30, 2010, we recognized an unrealized gain of $0.9 and an unrealized loss of $7.8 million, respectively, in unrealized loss on derivative instruments and other securities, net in our consolidated statements of operations and comprehensive income for the change in value of investments in interest-only and principal-only securities, net of prior period reversals. For the three and nine months ended September 30, 2011, we recognized a realized loss of $3.5 and $3.0 million, respectively, and for the three and nine months ended September 30, 2010, we recognized a realized loss of $1.2 million and $0.7 million, respectively, in gain on sale of agency securities, net, in our consolidated statements of operations and comprehensive income for the sales of interest-only and principal-only securities.
Pledged Assets
The following tables summarize our agency securities pledged as collateral under repurchase agreements, other debt, derivative agreements and prime broker agreements by type as of September 30, 2011 and December 31, 2010 (in thousands):
 

15



 
 
As of September 30, 2011
Agency Securities Pledged(1)
 
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Under Repurchase Agreements
 
 
 
 
 
 
 
 
Fair value
 
$
23,676,914

 
$
16,989,065

 
$
103,948

 
$
40,769,927

Amortized cost
 
23,181,446

 
16,666,601

 
101,949

 
39,949,996

Accrued interest on pledged agency securities
 
74,214

 
54,597

 
340

 
129,151

Under Other Debt Agreements
 
 
 
 
 
 
 
 
Fair value
 
60,796

 

 

 
60,796

Amortized cost
 
59,807

 

 

 
59,807

Accrued interest on pledged agency securities
 
243

 

 

 
243

Under Derivative Agreements
 
 
 
 
 
 
 
 
Fair value
 
324,818

 
356,372

 

 
681,190

Amortized cost
 
317,846

 
349,302

 

 
667,148

Accrued interest on pledged agency securities
 
1,085

 
1,124

 

 
2,209

Under Prime Broker Agreements
 
 
 
 
 
 
 
 
Fair value
 
32,636

 
8,872

 
1,397

 
42,905

Amortized cost
 
31,896

 
8,657

 
1,375

 
41,928

Accrued interest on pledged agency securities
 
113

 
29

 
5

 
147

Total Fair Value of Agency Securities Pledged and Accrued Interest
 
$
24,170,819

 
$
17,410,059

 
$
105,690

 
$
41,686,568

 ________________________ 
(1)
Agency securities pledged include pledged amounts of $2.69 billion related to agency securities sold but not yet settled as of September 30, 2011.

 
 
As of December 31, 2010
Agency Securities Pledged(2)
 
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Under Repurchase Agreements
 
 
 
 
 
 
 
 
Fair value
 
$
7,707,046

 
$
4,554,541

 
$
95,066

 
$
12,356,653

Amortized cost
 
7,709,785

 
4,591,245

 
94,860

 
12,395,890

Accrued interest on pledged agency securities
 
27,589

 
15,642

 
332

 
43,563

Under Other Debt Agreements
 
 
 
 
 
 
 
 
Fair value
 
77,906

 

 

 
77,906

Amortized cost
 
77,460

 

 

 
77,460

Accrued interest on pledged agency securities
 
325

 

 

 
325

Under Derivative Agreements
 
 
 
 
 
 
 
 
Fair value
 
36,651

 
30,306

 

 
66,957

Amortized cost
 
36,343

 
30,382

 

 
66,725

Accrued interest on pledged agency securities
 
156

 
118

 

 
274

Under Prime Broker Agreements
 
 
 
 
 
 
 
 
Fair value
 
6,061

 
5,997

 
2,032

 
14,090

Amortized cost
 
6,061

 
6,061

 
2,024

 
14,146

Accrued interest on pledged agency securities
 
28

 
21

 
8

 
57

Total Fair Value of Agency Securities Pledged and Accrued Interest
 
$
7,855,762

 
$
4,606,625

 
$
97,438

 
$
12,559,825

 ________________________ 
(2)
Agency securities pledged include pledged amounts of $244.7 million related to agency securities sold but not yet settled as of December 31, 2010.

The following table summarizes our agency securities pledged as collateral under repurchase agreements and other debt by remaining maturity as of September 30, 2011 and December 31, 2010 (dollars in thousands):

16



 
 
 
As of September 30, 2011(1)
 
As of December 31, 2010(1)
Remaining Maturity of Repurchase Agreements and Other Debt
 
Fair Value of Pledged Agency Securities
 
Amortized
Cost of Pledged Agency Securities
 
Accrued
Interest on
Pledged
Agency
Securities
 
Fair Value of Pledged Agency Securities
 
Amortized
Cost of Pledged Agency Securities
 
Accrued
Interest  on
Pledged
Agency
Securities
30 days or less
 
$
34,011,545

 
$
33,320,906

 
$
107,886

 
$
9,909,121

 
$
9,943,239

 
$
35,151

31 - 59 days
 
4,836,073

 
4,744,354

 
15,313

 
2,525,438

 
2,530,111

 
8,737

60 - 90 days
 
543,799

 
531,016

 
1,690

 

 

 

Greater than 90 days
 
1,439,306

 
1,413,527

 
4,505

 

 

 

Total
 
$
40,830,723

 
$
40,009,803

 
$
129,394

 
$
12,434,559

 
$
12,473,350

 
$
43,888

  ________________________ 
(1)
Agency securities pledged include pledged amounts of $2.69 billion and $244.7 million related to agency securities sold but not yet settled as of September 30, 2011 and December 31, 2010, respectively
Securitizations
All of our CMO securities are backed by fixed or adjustable-rate agency securities and Fannie Mae or Freddie Mac guarantees the payment of interest and principal and acts as the trustee and administrator of their respective securitization trusts. Our involvement with the consolidated CMO trust described below is limited to the agency securities transferred to the trust by the investment bank and the CMO securities subsequently held by us. Accordingly, we are not required to provide the beneficial interest holders of the CMO securities any financial or other support. Whether or not we were involved with the formation of the CMO or purchased the securities from third parties in separate transactions, our maximum exposure to loss related to our involvement with CMO trusts is the fair value of the CMO securities and interest-only securities held by us. As of September 30, 2011 and December 31, 2010, the fair value of all of our CMO securities, interest-only securities and principal-only securities, excluding the consolidated CMO trust discussed below, was $454.4 million and $458.6 million, respectively, or $458.3 million and $463.6 million, respectively, including the net asset value of the consolidated CMO trust discussed below.
During fiscal year 2010, we entered into a CMO transaction whereby we transferred agency securities with a cost basis of $85.9 million to an investment bank in exchange for cash proceeds of $80.8 million and at the same time entered into a commitment with the same investment bank to purchase a to-be-issued interest-only strip collateralized by the agency securities transferred for $5.1 million. The investment bank contributed the transferred agency securities to a securitization trust held by Fannie Mae in exchange for CMO securities issued by the trust. Once the transferred agency securities were transferred to the securitization trust, Fannie Mae may only remove such securities upon certain events. Pursuant to the pre-existing commitment, the investment bank transferred to us the interest-only security issued by the trust. Our primary purpose for entering into this transaction was to eliminate the need to finance the principal class by transferring it to third parties, while still retaining the underlying economics of a financed transaction for the transferred securities, which we viewed as favorable. We concluded that we were the primary beneficiary of the CMO trust based on our disproportionate economic interest and, accordingly, we consolidated the CMO trust as it related to the agency securities transferred by us and the related liabilities issued by the trust. The effect of consolidating the CMO trust was that the interest-only security received was eliminated and we continued to recognize the assets transferred to the securitization trust in our total agency securities held and recorded a corresponding liability for the debt issued by the securitization trust, which is classified as other debt in our accompanying consolidated balance sheets. As of September 30, 2011, we recognized agency securities with a total fair value of $60.8 million and a principal balance of $57.5 million collateralized the remaining debt outstanding issued by the securitization trust of $56.9 million. As of December 31, 2010, we recognized agency securities with a total fair value of $77.9 million and a principal balance of $73.5 million collateralized the remaining debt outstanding issued by the securitization trust of $72.9 million. Such agency securities can only be used to settle this debt and the holder(s) of the debt issued by the securitization trust have no recourse to us. Further, there are no arrangements that could require us to provide financial support to this securitization trust. The consolidation did not materially impact our accompanying consolidated statements of operations and comprehensive income and consolidated statements of cash flows.

Note 5. Repurchase Agreements and Other Debt
We pledge certain of our agency securities as collateral under repurchase arrangements with financial institutions, the terms and conditions of which are negotiated on a transaction-by-transaction basis. Interest rates on these borrowings are generally based on LIBOR plus or minus a margin and amounts available to be borrowed are dependent upon the fair value of the agency securities pledged as collateral, which fluctuates with changes in interest rates, type of security and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in fair value of pledged

17



agency securities, lenders may require us to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. As of September 30, 2011 and December 31, 2010, we have met all margin call requirements. Due to their short-term nature, repurchase agreements are carried at cost, which approximates fair value.
The following table summarizes our borrowings under repurchase arrangements and weighted average interest rates classified by original maturities as of September 30, 2011 and December 31, 2010 (dollars in thousands):

 
 
As of September 30, 2011
 
As of December 31, 2010
Original Maturity
 
Borrowings
Outstanding
 
Average
Interest
Rate
 
Weighted
Average Days
to Maturity
 
Borrowings
Outstanding
 
Average
Interest
Rate
 
Weighted
Average Days
to Maturity
1 month or less
 
$
18,946,631

 
0.27
%
 
12

 
$
3,306,175

 
0.32
%
 
12

1-2 months
 
8,110,844

 
0.28
%
 
22

 
5,648,155

 
0.31
%
 
20

2-3 months
 
4,789,136

 
0.26
%
 
26

 
1,496,452

 
0.29
%
 
33

3-6 months
 
5,662,617

 
0.25
%
 
34

 
1,229,310

 
0.29
%
 
43

6-9 months
 
278,758

 
0.41
%
 
215

 

 
%
 

9-12 months
 
1,053,633

 
0.50
%
 
348

 

 
%
 

Total / Weighted Average
 
$
38,841,619

 
0.28
%
 
30

 
$
11,680,092

 
0.31
%
 
22

As of September 30, 2011 and December 31, 2010, we did not have an amount at risk with any counterparty greater than 10% of our stockholders’ equity. On October 31, 2011, MF Global Holdings, Ltd., an affiliate of MF Global Inc., a counterparty to one of our master repurchase agreements, filed for Chapter 11 in a U.S. bankruptcy court. As of October 31, 2011, we had less than $1.0 million of counterparty exposure with regard to MF Global Inc.
Other debt of $56.9 million and $72.9 million as of September 30, 2011 and December 31, 2010, respectively, consists of other variable rate debt outstanding at LIBOR plus 25 basis points in connection with the consolidation of a structured transaction for which we are the primary beneficiary in our accompanying financial statements (see Note 4).

Note 6. Derivative and Other Hedging Instruments
In connection with our risk management strategy, we hedge a portion of our interest rate risk by entering into derivative and other hedging instrument contracts. We may enter into agreements for interest rate swap agreements, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts. We may also purchase or short TBA and U.S. Treasury securities, purchase or write put or call options on TBA securities or we may invest in other types of mortgage derivative securities, such as interest-only securities, and synthetic total return swaps, such as the IOS Index. Our risk management strategy attempts to manage the overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to stockholders. For additional information regarding our derivative instruments and our overall risk management strategy, please refer to the discussion of derivative and other hedging instruments in Note 3.
As of September 30, 2011 and December 31, 2010, our derivative and other hedging instruments were comprised primarily of interest rate swaps, which have the effect of modifying the repricing characteristics of our repurchase agreements and cash flows on such liabilities. Our interest rate swaps are used to manage the interest rate risk created by our variable rate short-term repurchase agreements. Under our interest rate swaps, we typically pay a fixed-rate and receive a floating rate based on one-month LIBOR with terms up to 10 years, but generally up to 5 years or less. As discussed further in Note 3, prior to September 30, 2011, our interest rate swaps were typically designated as cash flow hedges under ASC 815.
Derivative and other hedging instruments entered into in addition to interest rate swap agreements are intended to supplement our use of interest rate swaps and we do not currently expect our use of these instruments to be the primary protection against interest rate risk for our portfolio. These instruments are accounted for as either derivatives, but are not generally designated as hedges under ASC 815, or as other securities, with any changes in the fair values of the contracts prior to their settlement date included in earnings in unrealized gain (loss) on derivative instruments and other securities, net in our consolidated statements of operations and comprehensive income. We do not use derivative or other hedging instruments for speculative purposes.
Derivatives Designated as Hedging Instruments
Prior to September 30, 2011, we entered into interest rate swap agreements typically with the intention of qualifying for hedge accounting under ASC 815. However, during the quarter ended September 30, 2011, we elected to discontinue hedge accounting by a combination of not designating new interest rate swaps as qualifying cash flow hedges and de-designating all

18



of our remaining interest rate swaps on September 30, 2011 (see Note 3 for further information on our discontinuation of hedge accounting). As of December 31, 2010, we had net interest rate swap liabilities of $37.7 million designated as qualifying cash flow hedges.
The tables below summarize information about our outstanding interest rate swaps designated as cash flow hedges as of September 30, 2011 and December 31, 2010 (dollars in thousands):
 
 
 
 
 
As of
Interest Rate Swaps Designated
as Hedging Instruments
 
Balance Sheet Location
 
September 30,
2011
 
December 31, 2010
Interest rate swap assets
 
Derivative assets, at fair value
 
$

 
$
33,695

Interest rate swap liabilities
 
Derivative liabilities, at fair value
 

 
(71,417
)
 
 
 
 
$

 
$
(37,722
)

 
 
As of December 31, 2010
Remaining Term of Interest Rate Swaps
Designated as Hedging Instruments
 
Notional
Amount
 
Average
Fixed
Pay Rate
 
Average
Receive Rate
 
Net
Estimated
Fair Value
 
Average
Maturity
(Years)
1 year or less
 
$
750,000

 
1.40
%
 
0.26
%
 
$
(5,595
)
 
0.7

Greater than 1 year and less than 3 years
 
2,850,000

 
1.54
%
 
0.26
%
 
(32,865
)
 
2.5

Greater than 3 years and less than 5 years
 
2,850,000

 
1.78
%
 
0.26
%
 
738

 
4.3

Greater than 5 years
 

 
%
 
%
 

 

Total
 
$
6,450,000

 
1.63
%
 
0.26
%
 
$
(37,722
)
 
3.1


The following table summarizes information about our outstanding interest rate swaps designated as hedging instruments for the three and nine months ended September 30, 2011 and 2010 (in thousands):
 
Interest Rate Swaps Designated
as Hedging Instruments
 
Beginning
Notional
Amount
 
Additions
 
Expirations/
Terminations
 
Hedge De-Designations
 
Ending
Notional
Amount
Three months ended September 30, 2011
 
$
22,000,000

 
2,100,000

 
(200,000
)
 
(23,900,000
)
 
$

Three months ended September 30, 2010
 
$
3,000,000

 
1,200,000

 

 

 
$
4,200,000

Nine months ended September 30, 2011
 
$
6,450,000

 
17,900,000

 
(450,000
)
 
(23,900,000
)
 
$

Nine months ended September 30, 2010
 
$
2,050,000

 
2,150,000

 

 

 
$
4,200,000

The table below summarizes the effect of interest rate swaps designated as hedges under ASC 815 on our consolidated statement of operations for the three and nine months ended September 30, 2011 and 2010 (in thousands):
 

19



Interest Rate Swaps Designated as Hedging Instruments
 
Amount of
Gain or (Loss)
Recognized in
OCI
(Effective
Portion)
 
Location of Gain
or (Loss)
Reclassified from
OCI into
Earnings (Effective
Portion)
 
Amount of Gain or
(Loss) Reclassified
from OCI into
Earnings
(Effective Portion)
 
Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)
 
Amount of Gain
or (Loss)
Recognized in
Earnings
(Ineffective
Portion and
Amount
Excluded from
Effectiveness
Testing)
Three months ended September 30, 2011
 
$
(512,208
)
 
Interest Expense
 
$
(70,854
)
 
Loss on derivative
instruments and Other
securities, net
 
$
(914
)
Three months ended September 30, 2010
 
$
(39,823
)
 
Interest Expense
 
$
(13,261
)
 
Loss on derivative
instruments and Other
securities, net
 
$
(25
)
Nine months ended September 30, 2011
 
$
(706,972
)
 
Interest Expense
 
$
(140,074
)
 
Loss on derivative
instruments and Other
securities, net
 
$
(1,552
)
Nine months ended September 30, 2010
 
$
(99,428
)
 
Interest Expense
 
$
(40,332
)
 
Loss on derivative
instruments and Other
securities, net
 
$
(340
)

As of September 30, 2011, the amount of net deferred loss related to de-designated interest rate swaps was $744.4 million, which, provided we continue to hold repurchase agreements in excess of the notional value of our de-designated swap contracts, will be reclassified from OCI into earnings through interest expense over a weighted average remaining contractual term of 3.4 years. The net deferred loss expected to be reclassified from OCI into interest expense over the next twelve months is $208.8 million.
Additionally, during the nine months ended September 30, 2011 and the three and nine months ended September 30, 2010, we entered into or held forward contracts to purchase TBA and specified agency securities that were designated as cash flow hedges pursuant to ASC 815. We did not enter into such agreements during the three month period ended September 30, 2011. The following table summarizes information about our outstanding forward contracts designated as hedging instruments for the three and nine months ended September 30, 2011 and 2010 (dollars in thousands):

Purchases of TBAs and Forward
Settling Agency Securities
Designated as Hedging Instruments
 
Beginning
Notional Amount
 
Additions
 
Settlement /
Expirations
 
Ending
Notional  Amount
 
Fair Value
as of
Period End
 
Average
Maturity
as of
Period End
(Months)
Three months ended September 30, 2011
 
$

 

 

 
$

 
$

 

Three months ended September 30, 2010
 
$
80,000

 
175,000

 
(80,000
)
 
$
175,000

 
$
1,807

 
3

Nine months ended September 30, 2011
 
$
245,000

 

 
(245,000
)
 
$

 
$

 

Nine months ended September 30, 2010
 
$

 
321,303

 
(146,303
)
 
$
175,000

 
$
1,807

 
3

The effective portion of gains or losses for TBAs and forward settling specified agency securities is initially recognized in OCI for designated cash flow hedges and is subsequently reclassified within OCI for available-for-sale securities upon acquisition of the underlying hedged item. The ineffective portion of gains or losses is recognized in earnings in realized gain (loss) on derivative instruments and other securities, net.

The table below summarizes the effect of purchases of TBAs and forward settling securities designated as hedges under ASC 815 on our consolidated statement of operations and comprehensive income for the three and nine months ended September 30, 2011 and 2010 (in thousands).
 

20



Purchases of TBAs and Forward
Settling Agency Securities
Designated as Hedging Instruments
 
Amount of Gain or (Loss)  Recognized
in OCI for Cash
Flow Hedges
(Effective Portion)
 
Amount of Gain or
(Loss) Recognized in
OCI for Cash Flow
Hedges and
Reclassified to OCI for
Available-for-Sale
Securities
(Effective Portion)
 
Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and Amount Excluded from Effectiveness Testing)
 
Amount of Gain or
(Loss) Recognized
in Earnings
(Ineffective Portion
and Amount
Excluded from
Effectiveness
Testing)
Three months ended September 30, 2011
 
$

 
$

 
Loss on derivative instruments and Other
securities, net
 
$

Three months ended September 30, 2010
 
$
1,807

 
$

 
Loss on derivative
instruments and Other
securities, net
 
$

Nine months ended September 30, 2011
 
$
12

 
$
(3,213
)
 
Loss on derivative
instruments and Other
securities, net
 
$

Nine months ended September 30, 2010
 
$
1,807

 
$
1,262

 
Loss on derivative
instruments and Other
securities, net
 
$

Derivatives Not Designated as Hedging Instruments
As of September 30, 2011 and December 31, 2010, we had interest rate swap agreements outstanding that were not designated as hedges under ASC 815 consisting of interest rate swap agreements where we pay a fixed rate (“payer interest rate swaps”) and interest rate swap agreements where we receive a fixed rate (“receiver interest rate swaps”), summarized in the tables below (dollars in thousands).

.
 
 
As of September 30, 2011
Maturity of Interest Rate Swaps Not Designated as Hedging Instruments(1)
 
Notional
Amount
 
Average
Fixed
Pay Rate
 
Average
Receive Rate
 
Net
Estimated
Fair Value
 
Average
Maturity
(Years)
2011
 
$
300,000

 
1.28
%
 
0.23
%
 
$
(652
)
 
0.1

2012
 
750,000

 
2.01
%
 
0.23
%
 
(10,898
)
 
0.9

2013
 
3,050,000

 
1.06
%
 
0.23
%
 
(34,534
)
 
1.8

2014
 
7,300,000

 
1.22
%
 
0.24
%
 
(127,255
)
 
2.8

2015
 
7,700,000

 
1.51
%
 
0.28
%
 
(193,141
)
 
3.7

2016
 
7,550,000

 
2.17
%
 
0.23
%
 
(392,090
)
 
4.7

2018
 
100,000

 
1.79
%
 
0.37
%
 
(486
)
 
7.1

2021
 
200,000

 
2.00
%
 
0.37
%
 
1,460

 
10.1

Total Payer Interest Rate Swaps
 
$
26,950,000

 
1.58
%
 
0.25
%
 
$
(757,596
)
 
3.4

   ________________________
(1)
Amounts include the effect of deferred start dates for forward starting swaps of $1.9 billion ranging from one to three months from September 30, 2011.


 
 
As of December 31, 2010
Interest Rate Swaps Not
Designated as Hedging Instruments
 
Maturity
 
Notional
Amount
 
Average
Fixed Pay
(Receive)
Rate
 
Average
Receive
(Pay)
Rate
 
Net
Estimated
Fair Value
 
Average
Maturity
(Years)
Payer interest rate swaps
 
2015
 
$
250,000

 
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