7. Derivatives – Interest Rate Swap Agreements

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding. The Company’s primary source of debt funding is repurchase agreements. Since the interest rates on repurchase agreements change on a monthly basis, the Company is exposed to changing interest rates and the cash flows associated with these rates. To mitigate the effect of changes in these interest rates, the Company enters into interest rate swap agreements which help to manage the volatility in the interest rate exposures and their related cash flows.

Cash Flow Hedges of Interest Rate Risk

The Company finances its activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to three months. At each settlement date, the Company refinances each repurchase agreement at the market interest rate at that time. Since the interest rates on its repurchase agreements change on a monthly basis, the Company is constantly exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company currently uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The effect of these hedges is to synthetically lock up interest rates on a portion of the Company’s outstanding debt for the terms of the swaps. Although the Company’s objective is to hedge the risk associated with changing repurchase agreement rates, the Company’s hedges are benchmark interest rate hedges which perform with reference to LIBOR. Therefore, the Company remains at risk to the variability of the spread between repurchase agreement rates and LIBOR interest rates.

For qualifying derivatives under cash flow hedge accounting, effective hedge gains or losses are initially recorded in accumulated other comprehensive income and subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During the three months ended June 30, 2012 and 2011, these effective hedge losses totaled $59,168 and $127,913, respectively. During the six months ended June 30, 2012 and 2011, these effective hedge losses totaled $87,591 and $109,687, respectively. Ineffective hedge losses are recorded on a current basis in earnings and for the three months ended June 30, 2012 and 2011, the Company recorded $169 and $241, respectively. For the six months ended June 30, 2012 and 2011, the Company recorded $338 and $386, respectively, of hedge ineffectiveness losses in earnings. The hedge ineffectiveness is attributable primarily to differences in the reset dates on the Company’s swaps versus the refinancing dates of its repurchase agreements.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest is accrued and paid on the Company’s repurchase agreements. During the next 12 months, the Company estimates that an additional $111,681 will be reclassified as an increase to interest expense.

The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over an average period of 35 months. The table below shows the remaining term of the Company’s interest rate swaps as of June 30, 2012.


Maturity	Notional Amount		Remaining Term in Months		Weighted Average Fixed Interest Rate in Contract

12 months or less	$	800,000		6		1.90	%
Over 12 months to 24 months		1,200,000		19		1.90	%
Over 24 months to 36 months		3,800,000		31		1.78	%
Over 36 months to 48 months		2,700,000		42		1.30	%
Over 48 months to 60 months		1,800,000		53		0.99	%

Total	$	10,300,000		35		1.54	%

The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheets as of June 30, 2012 and December 31, 2011, respectively.

Asset Derivatives

Liability Derivatives

As of June 30, 2012

As of December 31, 2011

As of June 30, 2012

As of December 31, 2011

Balance Sheet

Fair Value

Balance Sheet

Fair Value

Balance Sheet

Fair Value

Balance Sheet

Fair Value

Interest rate hedge

Interest rate hedge asset

—

Interest rate hedge asset

—

Interest rate hedge liability

250,933

Interest rate hedge liability

219,167

Forward purchase commitment

Other assets

6,021

6,327

Account payable and other liabilities

—

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended June 30, 2012.


Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income (effective portion)		Location of loss recognized in income on derivative (ineffective portion)	Amount of loss recognized in income on derivative (ineffective portion)

Interest Rate	$	59,168	Interest Expense	$	28,352	Interest Expense	$	169

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended June 30, 2011.


Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income (effective portion)		Location of loss recognized in income on derivative (ineffective portion)	Amount of loss recognized in income on derivative (ineffective portion)

Interest Rate	$	127,913	Interest Expense	$	26,939	Interest Expense	$	241

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the six months ended June 30, 2012.


Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income (effective portion)		Location of gain recognized in income on derivative (ineffective portion)	Amount of gain recognized in income on derivative (ineffective portion)

Interest Rate	$	87,591	Interest Expense	$	56,164	Interest Expense	$	338

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the six months ended June 30, 2011.


Derivative type for cash flow hedge	Amount of loss recognized in OCI on derivative (effective portion)		Location of loss reclassified from accumulated OCI into income (effective portion)	Amount of loss reclassified from accumulated OCI into income (effective portion)		Location of gain recognized in income on derivative (ineffective portion)	Amount of gain recognized in income on derivative (ineffective portion)

Interest Rate	$	109,687	Interest Expense	$	44,412	Interest Expense	$	386

The following table presents the impact of the Company’s interest rate swap agreements on the Company’s accumulated other comprehensive income for the six months ended June 30, 2012 and the year ended December 31, 2011, respectively.


	June 30, 2012			December 31, 2011
Beginning balance	($	218,451	)	($	47,676	)
Unrealized loss on interest rate swaps		(87,591	)		(273,389	)
Reclassification of net losses included in income statement		56,164			102,614

Ending balance	$	(249,878	)	$	(218,451	)

Credit-risk-related Contingent Features

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender then the Company could also be declared in default on its derivative obligations.

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company’s GAAP shareholders’ equity declines by a specified percentage over a specified time period, or if the Company fails to maintain a minimum shareholders’ equity threshold, then the Company could be declared in default on its derivative obligations. The Company has agreements with several of its derivative counterparties that contain provisions regarding maximum leverage ratios. The most restrictive of these leverage covenants is that if the Company exceeds a leverage ratio of 10 to 1 then the Company could be declared in default on its derivative obligations with that counterparty.

As of June 30, 2012, the fair value of derivatives in a net liability position related to these agreements was $250,933. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of June 30, 2012. At June 30, 2012, the Company was in compliance with these requirements.