8.	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 values of interest rate swaptions are based on the fair value of the underlying interest rate swaps that the Company has the option to enter, and are based on inputs from the counterparty and pricing models. The fair value of Futures Contracts is based on quoted prices from the exchange on which they trade. The fair value of MBS forward purchase commitments was determined using the same methodology as MBS as described in Note 4. The fair value of forward purchase commitments for whole loans was determined using the same methodology as mortgage loans held for investment as described in Note 5. The Company applies fallout assumptions to the third-party pricing of forward purchase commitments regarding loans that the counterparties may not successfully issue. 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 December 31, 2014 and 2013, respectively.

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

Interest rate swaps and swaptions	Derivative assets	$	11,050	$	15,841
Futures contracts	Derivative assets		-		11,148
Forward purchase commitments - MBS	Derivative assets		16,101		-
		$	27,151	$	26,989


Interest rate swaps	Derivative liabilities	$	42,052	$	125,133
Futures contracts	Derivative liabilities		202,501		36,733
Forward purchase commitments - MBS	Derivative liabilities		36		5,741
Forward purchase commitments - mortgage loans	Derivative liabilities		2
		$	244,591	$	167,607

Interest Rate Swaps and Swaptions

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 Company is exposed to interest rates on its borrowings that change on a short-term basis, it enters into hedging agreements to mitigate the effect of these changes. 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 interest rate swaps. Although the Company’s objective is to hedge the risk associated with changing repurchase agreement rates, the Company’s interest rate 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 AOCI 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 interest rate swaps versus the refinancing dates of its repurchase agreements. See “Financial Statement Presentation” below for quantification of gains and losses on interest rate swaps for the three years ended December 31, 2014.

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 $30,715 will be reclassified out of AOCI as an increase to interest expense.

The Company continues to hedge its exposure to variability in future funding costs via interest rate swaps and other derivative instruments. 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 “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 interest rate swaps are also recorded in “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.

	Notional Value
	Years Ended December 31
	2014			2013
Beginning of period	$	10,500,000		$	10,700,000
Additions		-			800,000
Expirations and terminations		(2,200,000	)		(1,000,000	)
End of period	$	8,300,000		$	10,500,000

As of December 31, 2014, the weighted-average remaining term of the Company’s interest rate swaps is 16 months. Additional information regarding the Company’s interest rate swaps as of December 31, 2014 follows.

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

12 months or less	$	3,700,000		6		1.73%
Over 12 months to 24 months		2,400,000		18		0.92%
Over 24 months to 36 months		1,800,000		29		0.89%
Over 36 months to 48 months		400,000		38		0.96%

Total	$	8,300,000		16		1.28%

A swaption is a derivative instrument that gives the holder the option to enter into a pay-fixed interest rate swap in the future, if it so desires. As of December 31, 2014, the Company had four interest rate swaptions outstanding:

Options

Underlying Swaps

Swaptions

Original Cost

Fair Value

Wtd. Avg. Months to Expiration

Notional

Wtd. Avg. Fixed Pay Rate

Receive Rate

Wtd. Avg. Term (Years)

Fixed payer

20,080

4,561

992,300

2.74%

3 month LIBOR

The Company did not have any interest rate swaptions outstanding at December 31, 2013.

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 MBS and mortgage loans. The following tables presents the composition of the Company’s Futures Contracts as of December 31, 2014 and 2013, respectively.

	Fair Value
	December 31, 2014			December 31, 2013
Futures Contracts designed to replicate swaps	$	(202,202	)	$	(27,881	)
Futures Contracts designed to hedge value changes in forward purchases		(299	)		2,296
Total fair value of Futures Contracts	$	(202,501	)	$	(25,585	)

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

	Number of Contracts
	Years Ended December 31
	2014			2013
Beginning of period		95,327			-
New positions opened		136,610			125,860
Early settlements		(93,053	)		(28,164	)
Settlements at maturity		(8,810	)		(2,369	)
End of period		130,074			95,327

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 net income in the period in which the changes occur. See “Financial Statement Presentation” below for quantification of gains and losses on Futures Contracts for the years ended December 31, 2014 and 2013.

To Be Announced Securities Purchases and Mortgage Loan Commitments

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, as described in Note 2. 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) 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 Company had the following ARM securities forward purchase commitments with brokers as of December 31, 2014 and 2013.

	Face		Cost		Fair Market Value		Net Asset (Liability)

December 31, 2014	$	20,095	$	20,553	$	20,517	$	(36	)
December 31, 2013	$	-	$	-	$	-	$	-

15-year TBA contracts may be financed in the dollar roll market. As shown in “Financial Statement Presentation” below, income from dollar roll transactions and realized and unrealized gains and losses on TBA contracts are recognized in “Loss on derivative instruments, net.”

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

	Face		Cost		Fair Market Value		Net Asset (Liability)
December 31, 2014	$	3,400,000	$	3,509,871	$	3,521,816	$	11,945
December 31, 2013	$	600,000	$	632,270	$	627,187	$	(5,083	)

At December 31, 2014 and 2013, the Company also had ARM purchase commitments with mortgage originators with estimated net fair values of $4,156 and $(658), respectively, which were recognized in other comprehensive income.

At December 31, 2014, the Company had mortgage loan purchase commitments with mortgage originators with an estimated net fair value of $(2), which was recognized in “Loss on derivative instruments, net.” The Company did not begin entering purchase commitments on mortgage loans until 2014.

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 December 31, 2014.

	Assets/(Liabilities)			Cash Collateral Posted (Held)			Net Asset/(Liability)
Interest rate swaps	$	6,489		$	-		$	6,489
Interest rate swaptions		4,561			(1,558	)		3,003
Forward purchase commitments		16,101			-			16,101

Interest rate swaps	$	(42,052	)	$	66,653		$	24,601
Forward purchase commitments		(38	)		5,585			5,547
Futures contracts		(202,501	)		251,553			49,052

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		(5,741	)		14,005		8,264

The following table shows the components of “Loss on derivative instruments, net” for the three years ended December 31, 2014, 2013 and 2012. Impacts from the Company’s interest rate swaps subsequent to the September 30, 2013 hedge de-designation are included herein.

	Years Ended December 31
	2014			2013			2012
Interest rate swaps – fair value adjustments	$	73,729		$	25,036		$	-
Interest rate swaptions – fair value adjustments		(15,520	)		-			-
Interest rate swaps – monthly net settlements		(113,919	)		(30,985	)		-
Futures Contracts – fair value adjustments		(176,916	)		(25,585	)		-
Futures Contracts – realized losses		(29,423	)		(33,298	)		-
Mortgage loan purchase commitments - fair value adjustments		(2	)		-			-
TBA dollar roll income		92,008			5,605			-
Net realized and unrealized gains (losses) on TBA dollar rolls		28,610			(10,488	)		-
Loss on derivative instruments, net	$	(141,433	)	$	(69,715	)	$	-

See Note 2 for a discussion of TBA dollar roll transactions and TBA 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 interest rate swaps that were previously designated as cash flow hedges on the Company’s net income and other comprehensive income for the years ended December 31, 2014, 2013 and 2012.

	Years Ended December 31
	2014			2013			2012
Amount of gain (loss) recognized in OCI (effective portion)	$	-		$	15,030		$	(141,392	)
Amount of loss reclassified from OCI into net income as interest expense (effective portion)		(81,132	)		(116,847	)		(116,792	)
Amount of loss recognized in net income as interest expense (ineffective portion)		-			(205	)		(178	)

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

	Years Ended December 31
	2014			2013
Beginning balance	$	(111,174	)	$	(243,051	)
Unrealized gain on interest rate swaps		-			15,030
Reclassification of net losses included in income statement		81,132			116,847
Ending balance	$	(30,042	)	$	(111,174	)

Credit-risk-related Contingent Features

The Company has agreements with its interest rate swap and swaption 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 those 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 December 31, 2014, the Company was in compliance with these requirements.

As of December 31, 2014, the fair value of derivatives in a net liability position related to these agreements was $42,052. The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of December 31, 2014.