5. Derivatives

The Company’s derivatives are comprised of Swaps, 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 March 31, 2013 and December 31, 2012:

		Balance Sheet	March 31,			December 31,
Derivative Instrument	Designation	Location	2013			2012
(In Thousands)
Swaps, at fair value ($100.0 million notional at March 31, 2013)	Hedging	Assets	$	324		$	203
Linked Transactions, at fair value	Non-Hedging	Assets	$	12,572		$	12,704
Swaps, at fair value ($2.414 billion notional at March 31, 2013)	Hedging	Liabilities	$	(50,839	)	$	(63,034	)

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 sheet 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 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 March 31, 2013 and December 31, 2012:

Linked Transactions at March 31, 2013

Linked Repurchase Agreements					Linked MBS
			Weighted									Weighted
			Average									Average
Maturity or Repricing	Balance		Interest Rate		Non-Agency MBS	Fair Value		Amortized Cost		Par/Current Face		Coupon Rate
(Dollars in Thousands)					(Dollars in Thousands)
Within 30 days	$	23,236	1.67	%	Rated AA	$	12,654	$	11,578	$	11,937	5.00	%
>30 days to 90 days	10,900		1.45		Rated A	3,019		2,431		3,178		0.75
Total	$	34,136	1.60	%	Rated BBB	8,270		7,121		8,680		2.53
					Rated BB	7,162		6,540		7,234		2.70
					Rated D	15,478		13,894		18,606		5.82
					Total	$	46,583	$	41,564	$	49,635	4.27	%

Linked Transactions at December 31, 2012

Linked Repurchase Agreements					Linked MBS
			Weighted									Weighted
			Average									Average
Maturity or Repricing	Balance		Interest Rate		Non-Agency MBS	Fair Value		Amortized Cost		Par/Current Face		Coupon Rate
(Dollars in Thousands)					(Dollars in Thousands)
Within 30 days	$	13,672	1.57	%	Rated AA	$	13,588	$	12,817	$	13,192	5.00	%
>30 days to 90 days	21,599		1.66		Rated A	3,075		2,548		3,342		0.76
Total	$	35,271	1.63	%	Rated BBB	8,299		7,226		8,847		2.55
					Rated BB	7,365		6,854		7,593		2.75
					Rated D	15,501		14,372		19,303		5.80
					Total	$	47,828	$	43,817	$	52,277	4.28	%

At March 31, 2013, Linked Transactions also included $175,000 of associated accrued interest receivable and $50,000 of accrued interest payable. At December 31, 2012, Linked Transactions also included $185,000 of associated accrued interest receivable and $38,000 of accrued interest payable.

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 months ended March 31, 2013 and 2012:

Components of Unrealized Net Gains and Net Interest Income from Linked Transactions	Three Months Ended March 31,
(In Thousands)	2013			2012
Interest income attributable to MBS underlying Linked Transactions	$	668		$	2,288
Interest expense attributable to linked repurchase agreement borrowings underlying Linked Transactions	(140		)	(504		)
Change in fair value of Linked Transactions included in earnings	1,008			5,915
Unrealized net gains and net interest income from Linked Transactions	$	1,536		$	7,699

Derivative Hedging Instruments

Consistent with market practice, the Company has agreements with its Swap 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. Such financial covenants include minimum net worth requirements and maximum debt-to-equity ratios. 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 March 31, 2013. At March 31, 2013, 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 $53.1 million, including accrued interest payable of approximately $2.2 million.

The following table presents the assets pledged as collateral against the Company’s derivative contracts at March 31, 2013 and December 31, 2012:

(In Thousands)	March 31, 2013		December 31, 2012
Agency MBS, at fair value	$	57,119	$	68,915
Restricted cash	5,017		5,016
Total assets pledged against derivative contracts	$	62,136	$	73,931

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 March 31, 2013, 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 March 31, 2013, all of the Company’s derivatives were deemed effective for hedging purposes and no derivatives were terminated during the three months ended March 31, 2013 and March 31, 2012.

Swaps

The Company’s Swaps have the effect of modifying the repricing characteristics of the Company’s repurchase agreements and securitized debt 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 months ended March 31, 2013 and March 31, 2012.

At March 31, 2013, the Company had Swaps with an aggregate notional amount of $2.514 billion, which had net unrealized losses of $50.5 million, and extended 18 months on average with a maximum term of approximately 47 months. During the three months ended March 31, 2013, the Company entered into one new Swap with a notional amount of $50.0 million, a fixed-pay rate of 0.67% and an initial maturity of four years, and had Swaps amortize and/or expire with an aggregate notional amount of $56.0 million. The following table presents information about the Company’s Swaps at March 31, 2013 and December 31, 2012:

	March 31, 2013						December 31, 2012
			Weighted						Weighted
			Average		Weighted				Average		Weighted
	Notional		Fixed-Pay		Average Variable		Notional		Fixed-Pay		Average Variable
Maturity (1)	Amount		Interest Rate		Interest Rate (2)		Amount		Interest Rate		Interest Rate (2)
(Dollars in Thousands)
Within 30 days	$	287,832	1.85	%	0.21	%	$	25,828	3.88	%	0.28	%
Over 30 days to 3 months	239,443		1.36		0.21		30,185		3.96		0.26
Over 3 months to 6 months	357,012		4.18		0.21		527,275		1.63		0.21
Over 6 months to 12 months	75,902		4.00		0.25		391,063		4.17		0.22
Over 12 months to 24 months	1,053,361		2.06		0.21		685,042		2.28		0.22
Over 24 months to 36 months	350,000		2.07		0.20		710,171		1.97		0.21
Over 36 months to 48 months	150,000		0.54		0.20		150,000		1.03		0.21
Total Swaps	$	2,513,550	2.24	%	0.21	%	$	2,519,564	2.31	%	0.22	%

(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 derivative hedging instruments on its interest expense and the weighted average interest rate paid and received for such Swaps for the three months ended March 31, 2013 and 2012:

	Three Months Ended
	March 31,
(Dollars in Thousands)	2013			2012
Interest expense attributable to Swaps	$	12,969		$	20,823
Weighted average Swap rate paid	2.27		%	2.78		%
Weighted average Swap rate received	0.21		%	0.31		%

Impact of Hedging Instruments on AOCI

The following table presents the impact of the Company’s derivative hedging instruments on its AOCI for the three months ended March 31, 2013 and 2012:

	Three Months Ended
	March 31,
(In Thousands)	2013			2012
AOCI from derivative hedging instruments:
Balance at beginning of period	$	(62,831	)	$	(114,194	)
Unrealized gain on Swaps, net	12,316			12,091
Balance at end of period	$	(50,515	)	$	(102,103	)

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.