7. 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 swaps, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts. 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 2.

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 fair value of Futures Contracts is based on quoted prices from the exchange on which they trade. The table below presents the fair value of the Company’s derivative instruments as well as their classification on the balance sheets as of June 30, 2013 and December 31, 2012, respectively.


Derivative Instruments	Balance Sheet Location	June 30, 2013		December 31, 2012
Interest rate swaps	Interest rate hedge asset	$	25,921	$	-
Forward purchase commitments	Other assets		-		5,452
Futures contracts	Other assets		5,587		-
Interest rate swaps	Interest rate hedge liability	$	157,869	$	243,945
Forward purchase commitments	Accounts payable and other liabilities		43,724	$	-

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. 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 repurchase agreements 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, 2013 and 2012, these effective hedge gains (losses) which were reclassified into earnings totaled $57,294 and ($59,168), respectively. During the six months ended June 30, 2013 and 2012, these effective hedge gains (losses) which were reclassified into earnings totaled $51,385 and ($87,591), respectively. Ineffective hedge gains (losses) are recorded on a current basis in earnings and for the three months ended June 30, 2013 and 2012, the Company recorded $212 and ($169) of hedge ineffectiveness gain (loss) in earnings, respectively. For the six months ended June 30, 2013 and 2012, the Company recorded $96 and ($338), respectively, hedge ineffectiveness gain (loss) 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 $113,831 will be reclassified as an increase to interest expense.

The Company is hedging its exposure to the variability in future cash flows with interest rate swaps for current and forecasted transactions over a weighted-average period of 28 months. The table below shows the remaining term of the Company’s interest rate swaps as of June 30, 2013.


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

12 months or less	$	1,200,000	7	1.90%
Over 12 months to 24 months		3,800,000	19	1.78%
Over 24 months to 36 months		2,700,000	30	1.30%
Over 36 months to 48 months		2,600,000	43	0.91%
Over 48 months to 60 months		800,000	53	0.93%

Total	$	11,100,000	28	1.41%

Non-designated Hedge Instruments

For derivative financial instruments not designated as hedge instruments, realized and unrealized changes in fair value are recognized in the period in which the changes occur. The change in the fair value of Futures Contracts not designated and documented as hedges is recorded through earnings each period. During the three and six months ended June 30, 2013, the Company recognized a gain of $5,485 and $5,536, respectively, related to the change in fair value of these contracts. As of June 30, 2013, the fair value of these Futures Contracts was $5,587.

The Company uses Futures Contracts to 1) synthetically replicate an interest rate swap, or 2) offset the changes in value of its forward purchases of certain agency securities. The Company’s total Futures Contracts designed to replicate interest rate swaps had a notional equivalent amount of $800,000 at June 30, 2013 with a weighted average swap equivalent rate of 1.35% and a weighted average term of 56 months as of June 30, 2013. The Company did not own Futures Contracts at December 31, 2012.

The Company does not use either offsetting or netting to present any of its derivative assets or liabilities. The following table shows the gross amounts associated with the Company’s derivative financial instruments and the impact if netting were used as of June 30, 2013.


	Assets		Cash Collateral Posted		Net Amount
Interest rate swaps	$	25,921	$	-	$	25,921
Futures contracts		5,587		4,862		10,449

	Liabilities		Cash Collateral Posted		Net Amount
Interest rate swaps	$	157,869	$	144,348	$	13,521
Forward purchase commitments

The following table shows the gross amounts associated with the Company’s derivative financial instruments and the impact if netting were used as of December 31, 2012.


	Assets		Cash Collateral Posted		Net Amount
Forward purchase commitments	$	5,452	$	-	$	5,452

	Liabilities		Cash Collateral Posted		Net Amount
Interest rate swaps	$	243,945	$	281,021	$	(37,076)

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three months ended June 30, 2013.


Derivative type for cash flow hedge	Amount of gain 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	$	57,294	Interest Expense	$	30,585	Interest Expense	$	212

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 six months ended June 30, 2013.


Derivative type for cash flow hedge	Amount of gain 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	$	51,385	Interest Expense	$	60,515	Interest Expense	$	96

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 following table presents the impact of the Company’s interest rate swap agreements on the Company’s accumulated other comprehensive income (loss) for the six months ended June 30, 2013 and the year ended December 31, 2012, respectively.


	June 30, 2013		December 31, 2012

Beginning balance		(243,051)		($218,451)
Unrealized gain (loss) on interest rate swaps		51,385		(141,392)
Reclassification of net losses included in income statement		60,515		116,792

Ending balance		$ (131,151)		$ (243,051)

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 June 30, 2013, the Company was in compliance with these requirements.

As of June 30, 2013, the fair value of derivatives in a net liability position related to these agreements was $0. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of June 30, 2013.