Derivatives

9 Months Ended

Sep. 30, 2011

Derivatives

Derivatives

4. Derivatives

The Company’s derivatives are comprised of Swaps and Swaptions, which are designated as cash flow hedges against the interest rate risk associated with its borrowings, and Linked Transactions, which are not designated as hedging instruments.  The following table presents the fair value of the Company’s derivative instruments and their balance sheet location at September 30, 2011 and December 31, 2010:

Derivative Instrument (In Thousands)	Designation	Balance Sheet Location	September 30, 2011			December 31, 2010
Swaps, at fair value ($125.0 million notional)	Hedging	Assets	$	53		$	—
Swaptions, at fair value ($100.0 million notional)	Hedging	Assets	$	28		$	—
Linked Transactions, at fair value	Non-Hedging	Assets	$	64,494		$	179,915
Swaps, at fair value ($3.379 billion notional)	Hedging	Liabilities	$	(134,712	)	$	(139,142	)

Linked Transactions

The Company’s Linked Transactions are evaluated on a combined basis, reported as forward (derivative) instruments and presented as assets on the Company’s consolidated balance sheets at fair value.  The fair value of Linked Transactions reflect the value of the underlying Non-Agency MBS, linked repurchase agreement borrowings and accrued interest receivable/payable on such instruments.  The Company’s Linked Transactions are not designated as hedging instruments and, as a result, the change in the fair value and net interest income from Linked Transactions is reported in Other (Loss)/Income on the Company’s consolidated statements of operations.

The following tables present certain information about the Non-Agency MBS and repurchase agreements underlying the Company’s Linked Transactions at September 30, 2011 and December 31, 2010:

Linked Transactions at September 30, 2011
Linked Repurchase Agreements					Linked MBS
Maturity or Repricing (Dollars in Thousands)	Balance		Weighted Average Interest Rate		Non-Agency MBS (Dollars in Thousands)	Fair Value		Amortized Cost		Par/Current Face		Weighted Average Coupon Rate
Within 30 days	$	113,013	1.67	%	Rated AAA	$	30,553	$	30,682	$	31,507	3.32	%
>30 days to 90 days	64,647		1.64		Rated AA	19,193		18,361		18,816		5.00
>90 days to 180 days	15,300		1.35		Rated BBB	27,141		26,602		30,795		3.07
Total	$	192,960	1.63	%	Rated CCC	32,509		33,075		41,841		4.51
					Rated CC	79,891		82,143		107,837		5.89
					Rated C	35,912		38,739		49,970		5.97
					Rated D	31,170		31,325		41,013		5.44
					Total	$	256,369	$	260,927	$	321,779	5.09	%
Linked Transactions at December 31, 2010
Linked Repurchase Agreements					Linked MBS
Maturity or Repricing (Dollars in Thousands)	Balance		Weighted Average Interest Rate		Non-Agency MBS (Dollars in Thousands)	Fair Value		Amortized Cost		Par/Current Face		Weighted Average Coupon Rate
Within 30 days	$	289,522	1.62	%	Rated AAA	$	46,710	$	46,367	$	47,151	4.13	%
>30 days to 90 days	277,765		1.62		Rated AA	57,634		54,176		61,389		3.51
Total	$	567,287	1.62	%	Rated A	36,440		34,620		41,984		2.53
					Rated BBB	69,397		66,848		78,741		3.38
					Rated BB	14,536		14,456		17,513		2.51
					Rated B	129,962		121,198		139,763		4.28
					Rated CCC	216,398		211,302		255,667		4.98
					Rated CC	89,833		86,509		110,518		5.45
					Rated C	78,181		78,038		100,204		5.77
					Unrated	5,278		5,220		10,350		6.00
					Total	$	744,369	$	718,734	$	863,280	4.56	%

The following table presents certain information about the components of the unrealized net gains and net interest income from Linked Transactions included in the Company’s consolidated statements of operations for the three and nine months ended September 30, 2011 and 2010:

Components of Unrealized Net Gains and Net Interest Income from Linked Transactions	Three Months Ended September 30,						Nine Months Ended September 30,
(In Thousands)	2011			2010			2011			2010
Interest income attributable to MBS underlying Linked Transactions	$	4,631		$	9,520		$	21,475		$	24,748
Interest expense attributable to linked repurchase agreement borrowings underlying Linked Transactions	(864		)	(1,722		)	(3,938		)	(4,392		)
Change in fair value of Linked Transactions included in earnings	(3,034		)	13,509			(7,567		)	20,948
Unrealized net gains and net interest income from Linked Transactions	$	733		$	21,307		$	9,970		$	41,304

Derivative Hedging Instruments

Consistent with market practice, the Company has agreements with its Swap and Swaption counterparties that provide for the posting of collateral based on the fair values of its derivative contracts.  Through this margining process, either the Company or its derivative counterparty may be required to pledge cash or securities as collateral.  Collateral requirements vary by counterparty and change over time based on the market value, notional amount and remaining term of the derivative contract.  Certain derivative contracts provide for cross collateralization with repurchase agreements with the same counterparty.

A number of the Company’s derivative contracts include financial covenants, which, if breached, could cause an event of default or early termination event to occur under such agreements.  If the Company were to cause an event of default or trigger an early termination event pursuant to one of its derivative contracts, the counterparty to such agreement may have the option to terminate all of its outstanding derivative contracts with the Company and, if applicable, any close-out amount due to the counterparty upon termination of the derivative contracts would be immediately payable by the Company.  The Company was in compliance with all of its financial covenants through September 30, 2011.  At September 30, 2011, the aggregate fair value of assets needed to immediately settle derivative contracts that were in a liability position to the Company, if so required, was approximately $134.7 million.

The following table presents the assets pledged as collateral against the Company’s derivative contracts at September 30, 2011 and December 31, 2010:

(In Thousands)	September 30, 2011		December 31, 2010
Agency MBS, at fair value	$	146,380	$	153,534
Restricted cash	22,498		35,083
Total assets pledged against derivative contracts	$	168,878	$	188,617

The use of derivative hedging instruments exposes the Company to counterparty credit risk.  In the event of a default by a derivative counterparty, the Company may not receive payments to which it is entitled under its derivative agreements, and may have difficulty recovering its assets pledged as collateral against such agreements.  If, during the term of a derivative contract, a counterparty should file for bankruptcy, the Company may experience difficulty recovering its assets pledged as collateral which could result in the Company having an unsecured claim against such counterparty’s assets for the difference between the fair value of the derivative and the fair value of the collateral pledged to such counterparty.  At September 30, 2011, all of the Company’s derivative counterparties were rated A or better by a Rating Agency.

The Company’s derivative hedging instruments, or a portion thereof, could become ineffective in the future if the associated repurchase agreements or securitized debt that such derivatives hedge fail to exist or fail to have terms that match those of the derivatives that hedge such borrowings.  At September 30, 2011, all of the Company’s derivatives were deemed effective for hedging purposes and no derivatives were terminated during the three and nine months ended September 30, 2011 and September 30, 2010.

Swaps

The Company’s Swaps have the effect of modifying the repricing characteristics of the Company’s repurchase agreements and cash flows for such liabilities.  To date, no cost has been incurred at the inception of a Swap, pursuant to which the Company agrees to pay a fixed rate of interest and receive a variable interest rate, generally based on one-month or three-month London Interbank Offered Rate (“LIBOR”), on the notional amount of the Swap. The Company has not recognized any change in the value of its derivative hedging instruments in earnings as a result of the hedge or a portion thereof being ineffective during the three and nine months ended September 30, 2011 and September 30, 2010.

At September 30, 2011, the Company had Swaps with an aggregate notional amount of $3.504 billion, which had gross unrealized losses of $134.7 million, gross unrealized gains of $53,000 and extended 24 months on average with a maximum term of approximately 53 months.  During the three and nine months ended September 30, 2011, the Company entered into Swaps with an aggregate notional amount of $20.0 million and $1.215 billion, respectively, and had Swaps expire with an aggregate notional amount of $131.4 million and $516.5 million, respectively.  The following table presents information about the Company’s Swaps at September 30, 2011 and December 31, 2010:

	September 30, 2011						December 31, 2010
Maturity (1) (Dollars in Thousands)	Notional Amount		Weighted Average Fixed-Pay Interest Rate		Weighted Average Variable Interest Rate (2)		Notional Amount		Weighted Average Fixed-Pay Interest Rate		Weighted Average Variable Interest Rate (2)
Within 30 days	$	36,696	4.06	%	0.25	%	$	55,267	3.90	%	0.28	%
Over 30 days to 3 months	89,402		4.16		0.29		160,589		4.35		0.27
Over 3 months to 6 months	154,057		4.35		0.26		169,258		4.02		0.28
Over 6 months to 12 months	463,094		3.30		0.25		257,482		4.09		0.28
Over 12 months to 24 months	1,281,452		3.18		0.25		833,302		4.40		0.27
Over 24 months to 36 months	598,371		2.16		0.24		849,351		3.10		0.26
Over 36 months to 48 months	830,892		2.17		0.24		360,042		3.32		0.27
Over 48 months to 60 months	50,000		2.13		0.24		120,170		2.87		0.27
Total Swaps	$	3,503,964	2.85	%	0.25	%	$	2,805,461	3.74	%	0.27	%

(1) Each maturity category reflects contractual amortization and/or maturity of notional amounts.

(2) Reflects the benchmark variable rate due from the counterparty at the date presented, which rate adjusts monthly or quarterly based on one-month or three-month LIBOR, respectively.

The following table presents the net impact of the Company’s Swaps on its interest expense and the weighted average interest rate paid and received for such Swaps for the three and nine months ended September 30, 2011 and 2010:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(Dollars in Thousands)	2011			2010			2011			2010
Interest expense attributable to Swaps	$	24,322		$	27,758		$	73,091		$	85,474
Weighted average Swap rate paid	2.88		%	3.84		%	3.24		%	4.02		%
Weighted average Swap rate received	0.21		%	0.36		%	0.24		%	0.30		%

Swaptions

In June 2011, the Company purchased a Swaption, for which it paid a premium of $915,000, that provides the Company with the right to enter into a fixed-pay Swap at termination of the option period in January 2012.  The terms of the Swap that the Company may enter into are as follows:  $100.0 million notional; four-year term; fixed strike rate 1.90%; variable index equal to one month LIBOR.  Swaptions are used as a hedge against the risk of changes in the interest component above a specified level on a portion of forecasted one-month fixed rate borrowings.  At September 30, 2011, the Company’s Swaption had a fair value of $28,000.  During the three months ended September 30, 2011, the Company’s Swaptions decreased in value by $227,000, which was reflected in other comprehensive income, reflecting changes in the intrinsic value component of the Swaption, and $899,000 of expense in other income, reflecting changes in the time-value component of the Swaption.  For the nine months ended September 30, 2011, the Company recognized $887,000 of expense in other income, reflecting changes in the time-value component of the Swaption.

Impact of Derivative Hedging Instruments on Accumulated Other Comprehensive Income/(Loss)

The following table presents the impact of the Company’s Swaps on its accumulated other comprehensive income for the three and nine months ended September 30, 2011 and 2010:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(In Thousands)	2011			2010			2011			2010
Accumulated other comprehensive loss from derivative hedging instruments:
Balance at beginning of period	$	(124,404	)	$	(167,679	)	$	(139,142	)	$	(152,463	)
Unrealized (loss)/gain on Swaps, net	(10,028		)	(7,624		)	4,483			(22,840		)
Unrealized loss on Swaptions	(227		)	—			—			—
Balance at end of period	$	(134,659	)	$	(175,303	)	$	(134,659	)	$	(175,303	)

Counterparty Credit Risk

By using derivative hedging instruments, the Company is exposed to counterparty credit risk if counterparties to the derivative contracts do not perform as expected.  If a counterparty fails to perform, the Company’s counterparty credit risk is equal to the amount reported as a derivative asset on its balance sheet to the extent that amount exceeds collateral obtained from the counterparty or, if in a net liability position, the extent to which collateral posted exceeds the liability to the counterparty.  The amounts reported as a derivative asset/(liability) are derivative contracts in a gain/(loss) position, and to the extent subject to master netting arrangements, net of derivatives in a loss/(gain) position with the same counterparty and collateral received/(pledged).  The Company attempts to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, executing master netting arrangements and obtaining collateral, where appropriate.  Counterparty credit risk related to the Company’s derivative hedging instruments is considered in determining fair value of such derivatives and its assessment of hedge effectiveness.