Derivatives - Interest Rate Swap Agreements

9 Months Ended

Sep. 30, 2012

Derivatives - Interest Rate Swap Agreements

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 usually 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 September 30, 2012 and 2011, these effective hedge losses totaled $51,883 and $150,557, respectively. During the nine months ended September 30, 2012 and 2011, these effective hedge losses totaled $85,842 and $260,244, respectively. Ineffective hedge gains/(losses) are recorded on a current basis in earnings and for the three months ended September 30, 2012 and 2011, the Company recorded $17 and ($130), respectively. For the nine months ended September 30, 2012 and 2011, the Company recorded ($321) and ($515), respectively, of hedge ineffectiveness gains/(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 $120,235 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 34 months. The table below shows the remaining term of the Company’s interest rate swaps as of September 30, 2012.

Maturity	Notional Amount		Remaining Term in Months		Weighted Average Fixed Interest Rate in Contract
12 months or less	$	900,000		7		2.00	%
Over 12 months to 24 months		1,600,000		20		1.92	%
Over 24 months to 36 months		4,000,000		31		1.70	%
Over 36 months to 48 months		2,400,000		42		1.10	%
Over 48 months to 60 months		2,000,000		53		0.88	%
Total	$	10,900,000		34		1.48	%

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 September 30, 2012 and December 31, 2011, respectively.

Asset Derivatives

Liability Derivatives

As of September 30, 2012

As of December 31, 2011

As of September 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

$

273,120

Interest rate hedge liability

$

219,167

Forward purchase commitment

Other assets

26,843

Other Assets

6,327

Account payable and other liabilities

—

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 September 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 gain recognized in income on derivative (ineffective  portion)
Interest Rate	$	51,833	Interest Expense	$	29,679	Interest Expense	$	17

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended September 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	$	150,557	Interest Expense	$	30,694	Interest Expense	$	130

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the nine months ended September 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 loss recognized in income on derivative (ineffective  portion)
Interest Rate	$	139,474	Interest Expense	$	85,842	Interest Expense	$	321

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the nine months ended September 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 loss recognized in income on derivative (ineffective  portion)
Interest Rate	$	260,244	Interest Expense	$	75,106	Interest Expense	$	515

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

	September 30, 2012			December 31, 2011
Beginning balance	($	218,451	)	($	47,676	)
Unrealized loss on interest rate swaps		(139,474	)		(273,389	)
Reclassification of net losses included in income statement		85,842			102,614
Ending balance	$	(272,083	)	$	(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. At September 30, 2012, the Company was in compliance with these requirements.

As of September 30, 2012, the fair value of derivatives in a net liability position related to these agreements was $273,120. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of September 30, 2012.