7. Derivatives and Other Hedging Instruments

In connection with the Company’s risk management strategy, the Company hedges a portion of its interest rate risk by entering into derivative contracts. The Company may enter into agreements for interest rate swaps, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts. The Company’s risk management strategy attempts to manage the overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to shareholders. For additional information regarding the Company’s derivative instruments and its overall risk management strategy, please refer to the discussion of derivative 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 consolidated balance sheets as of March 31, 2014 and December 31, 2013, respectively.

Derivative Instruments	Balance Sheet Location	March 31, 2014		December 31, 2013

Interest rate swaps	Interest rate swap asset	$	12,703	$	15,841
Futures contracts	Other assets		5,617		11,148
Forward purchase commitments	Other assets		2,042		-

Interest rate swaps	Interest rate swap liability	$	106,132	$	125,133
Futures contracts	Futures contract liability		48,584		36,733
Forward purchase commitments including TBA dollar rolls	Accounts payable and other liabilities		13,634		5,741

Interest Rate Swaps

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 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 lockup 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 swaps are benchmark interest rate swaps 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.

Until September 30, 2013, the Company elected cash flow hedge accounting for its interest rate swaps. Under cash flow hedge accounting, effective hedge gains or losses are initially recorded in other comprehensive income and subsequently reclassified into net income in the period that the hedged forecasted transaction affects earnings. Ineffective hedge gains and losses are recorded on a current basis 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. See “Financial Statement Presentation” below for quantification of gains and losses for the three months ended March 31, 2014 and 2013.

On September 30, 2013, the Company de-designated its interest rate swaps as cash flow hedges, thus terminating cash flow hedge accounting. As long as the forecasted rollovers of the related repurchase agreements are still expected to occur, amounts in AOCI related to the cash flow hedges through September 30, 2013 will remain in AOCI and will continue to be reclassified to interest expense as interest is accrued and paid on the related repurchase agreements. During the next 12 months, the Company estimates that an additional $72,052 will be reclassified out of AOCI as an increase to interest expense.

The Company will continue to hedge its exposure to variability in future funding costs via interest rate swaps. As a result of discontinuing hedge accounting, beginning October 1, 2013, changes in the fair value of the Company’s interest rate swaps are recorded in “Gain (loss) on derivative instruments, net” in the consolidated statements of income, consistent with the Company’s historical accounting for Futures Contracts, as described below. Monthly net cash settlements under the swaps are also recorded in “Gain (loss) on derivative instruments, net” beginning October 1, 2013.

The volume of activity for the Company’s interest rate swap instruments is shown in the table below.

	Three Months Ended March 31
	2014			2013
Notional amount, beginning of period	$	10,700,000		$	10,700,000
Additions		-			600,000
Expirations and terminations		(600,000	)		(200,000	)
Notional amount, end of period	$	10,100,000		$	11,100,000

As of March 31, 2014, the weighted-average remaining term of the Company’s interest rate swaps is 22 months. Additional information regarding the Company’s interest rate swaps as of March 31, 2014 follows.

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

12 months or less	$	2,800,000		8		1.80%
Over 12 months to 24 months		3,300,000		17		1.53%
Over 24 months to 36 months		2,400,000		30		0.95%
Over 36 months to 48 months		1,600,000		41		0.87%

Total	$	10,100,000		22		1.36%

Eurodollar Futures Contracts

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. As of March 31, 2014 and December 31, 2013, the fair value of all Futures Contracts was a liability of $(42,967) and $(25,585), respectively.

	Fair Value
	March 31, 2014			December 31, 2013
Futures Contracts designed to replicate swaps	$	(45,537	)	$	(27,881	)
Futures Contracts designed to hedge value changes in forward purchases		2,570			2,296
Total fair market value of Futures Contracts	$	(42,967	)	$	(25,585	)

The volume of activity for the Company’s Futures Contracts is shown in the table below.

	Number of Contracts
As of December 31, 2013		95,327
New positions opened		77,821
Early settlements		(56,817	)
Settlements at maturity		(2,006	)
As of March 31, 2014		114,325

Each Futures Contract embodies $1 million of notional value and is effective for a term of approximately three months.

The Company has not designated its Futures Contracts as hedges for accounting purposes. As a result, realized and unrealized changes in fair value thereon are recognized in earnings in the period in which the changes occur. During the three months ended March 31, 2014, the Company recognized realized and unrealized losses on Futures Contracts of $(18,606) and $(17,382), respectively, in “Gain (loss) on derivative instruments, net.” The Company recognized a realized gain of $51 on Futures Contracts during the three months ended March 31, 2013.

To Be Announced Securities Purchases

The Company purchases certain of its investment securities in the forward market. The Company purchases ARM TBA contracts and 15-year TBA contracts from dealers. ARM TBA contracts are not a frequently-traded security and are generally used to acquire MBS for the portfolio. 15-year TBA contracts are a highly liquid security, and may be physically settled, net settled or traded as an investment. The Company also has commitments with various mortgage origination companies to purchase their production as it becomes securitized. Forward purchases do not qualify for trade date accounting and are considered derivatives for financial statement purposes. The net fair value of the forward commitment is reported on the balance sheet as an asset (or liability). Whether the unrealized gain (or loss) is recognized in net income or other comprehensive income depends on whether or not the commitment has been designated as an accounting hedge, as discussed in Note 2.

The following table shows the ARM securities forward purchase commitments shown as a net asset in other assets on the balance sheets as of March 31, 2014 and December 31, 2013.


		Face		Cost		Fair Value		Net Asset

March 31, 2014	$	70,000	$	71,839	$	72,040	$	201
December 31, 2013	$	-	$	-	$	-	$	-

15-year TBA contracts may be financed in the dollar roll market. Income from dollar roll transactions and realized and unrealized gains and losses on TBA contracts are recognized in “Gain (loss) on derivative instruments, net.”

At March 31, 2014 and December 31, 2013, the Company had the following 15-year TBA dollar roll securities:

Face

Cost

Fair Value

Net Asset

(Liability)

March 31, 2014

3,400,000

3,565,399

3,551,765

(13,634

)

December 31, 2013

600,000

632,270

627,187

(5,083)

At March 31, 2014 and December 31, 2013, the Company also had estimated purchase commitments with mortgage originators with a net fair value in the amount of $1,841 and ($658), respectively.

Financial Statement Presentation

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 March 31, 2014.

	Assets/(Liabilities)			Cash Collateral Posted		Net Asset/(Liability)
Interest rate swaps	$	12,703		$	-	$	12,703
Futures contracts		5,617			-		5,617
Forward purchase commitments		2,042			-		2,042

Interest rate swaps	$	(106,132	)	$	111,898	$	5,766
Futures contracts		(48,584	)		106,298		57,714
Forward purchase commitments including TBA dollar rolls		(13,634	)		13,395		(239)

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, 2013.

	Assets/(Liabilities)			Cash Collateral Posted		Net Asset/(Liability)
Interest rate swaps	$	15,841		$	-	$	15,841
Futures contracts		11,148			-		11,148

Interest rate swaps	$	(125,133	)	$	133,661	$	8,528
Futures contracts		(36,733	)		77,713		40,980
Forward purchase commitments including TBA dollar rolls		(5,741	)		14,005		8,264

The following table shows the components of “Gain (loss) on derivative instruments, net” for the three months ended March 31, 2014 and 2013. Impacts from the Company’s interest rate swaps subsequent to the September 30, 2013 hedge de-designation are included herein.

	Three Months Ended March 31
	2014			2013
Interest rate swaps – fair value adjustments	$	15,863		$	-
Interest rate swaps – monthly net settlements		(29,412	)		-
Futures Contracts – fair value adjustments		(17,382	)		-
Futures Contracts – realized gains (losses)		(18,606	)		51
TBA dollar roll income		20,821			-
Realized and unrealized losses on TBA securities		(12,899	)		-
Gain (loss) on derivative instruments, net	$	(41,615	)	$	51

See Note 2 for discussion of dollar roll transactions and dollar roll income.

As discussed above, effective September 30, 2013, the Company discontinued cash flow hedge accounting for its interest rate swaps. The table below presents the effect of the swaps that were previously designated as cash flow hedges on the Company’s comprehensive income for the three months ended March 31, 2014 and 2013.

	Three Months Ended March 31
	2014			2013
Amount of gain (loss) recognized in OCI (effective portion)	$	-		$	(5,907	)
Amount of loss reclassified from OCI into net income as interest expense (effective portion)		(24,684	)		(29,929	)
Amount of loss recognized in net income as interest expense (ineffective portion)		-			(116	)

The following table presents the impact of the Company’s interest rate swap agreements on the Company’s AOCI for the three months ended March 31, 2014 and the year ended December 31, 2013.


	Three Months Ended March 31, 2014			Year Ended December 31, 2013
Beginning balance	$	(111,174	)	$	(243,051	)
Unrealized gain on interest rate swaps		-			15,030
Reclassification of net losses included in income statement		24,684			116,847
Ending balance	$	(86,490	)	$	(111,174	)

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 March 31, 2014, the Company was in compliance with these requirements.

As of March 31, 2014, the fair value of derivatives in a net liability position related to these agreements was $93,429. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of March 31, 2014.