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. We may also purchase or short TBA and U.S. Treasury securities, purchase or write put or call options on TBA securities or we may invest in other types of mortgage derivative securities, such as interest-only securities, and synthetic total return swaps, such as the Markit IOS Index. 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.

Prior to September 30, 2011, our interest rate swaps were typically designated as cash flow hedges under ASC 815; however, as of September 30, 2011, we elected to discontinue hedge accounting for our interest rate swaps in order to increase our funding flexibility. For fiscal years 2012 and 2011, we reclassified $205 million and $54 million, respectively, of net deferred losses from accumulated OCI into interest expense related to our de-designated interest rate swaps and recognized an equal, but offsetting, amount in other comprehensive income. Our total net periodic interest costs on our swap portfolio were $457 million and $89 million for fiscal years 2012 and 2011, respectively. The difference of $252 million and $35 million for fiscal years 2012 and 2011, respectively, is reported in our accompanying consolidated statement of comprehensive income in gain (loss) on derivative instruments and other securities, net. As of December 31, 2012, the remaining net deferred loss in accumulated OCI related to de-designated interest rate swaps was $486 million and will be reclassified from OCI into interest expense over a remaining weighted average period of 2.9 years. The net deferred loss expected to be reclassified from OCI into interest expense over the next twelve months is $189 million as of December 31, 2012.

Derivative Assets (Liabilities), at Fair Value

The table below summarizes fair value information about our derivative assets and liabilities as of December 31, 2012 and 2011 (in millions):



		December 31,
Derivatives Instruments	Balance Sheet Location	2012			2011
Interest rate swaps	Derivative assets, at fair value	$	14		$	13
Payer swaptions	Derivative assets, at fair value	171			11
Purchase of TBA and forward settling agency securities	Derivative assets, at fair value	116			54
Sale of TBA and forward settling agency securities	Derivative assets, at fair value	—			3
Markit IOS total return swaps - long	Derivative assets, at fair value	—			1
		$	301		$	82
Interest rate swaps	Derivative liabilities, at fair value	$	(1,243	)	$	(795	)
U.S. Treasury futures - short	Derivative liabilities, at fair value	—			(14		)
Purchase of TBA and forward settling agency securities	Derivative liabilities, at fair value	(1		)	—
Sale of TBA and forward settling agency securities	Derivative liabilities, at fair value	(20		)	(44		)
		$	(1,264	)	$	(853	)

Additionally, as of December 31, 2012 and 2011, we had obligations to return U.S. Treasury securities borrowed under reverse repurchase agreements accounted for as securities borrowing transactions at a fair value of $11.8 billion and $899 million, respectively. The borrowed securities were used to cover short sales of U.S. Treasury securities from which we received total proceeds of $11.7 billion and $880 million, respectively. The change in fair value of the borrowed securities is recorded in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.

The following tables summarize our interest rate swap agreements outstanding as of December 31, 2012 and 2011 (dollars in millions):



	December 31, 2012
Interest Rate Swaps ⁽¹⁾	Notional Amount		Average Fixed Pay Rate		Average Receive Rate		Net Estimated Fair Value			Average Maturity (Years)
Three years or less	$	14,600	1.23	%	0.26	%	$	(294	)	2.0
Greater than 3 years and less than/equal to 5 years	20,250		1.48	%	0.29	%	(666		)	4.1
Greater than 5 years and less than/equal to 7 years	5,600		1.53	%	0.34	%	(163		)	6.1
Greater than 7 years and less than/equal to 10 years	5,200		1.89	%	0.35	%	(113		)	9.2
Greater than 10 years	1,200		1.79	%	0.31	%	7			10.2
Total Payer Interest Rate Swaps	$	46,850	1.46	%	0.29	%	$	(1,229	)	4.4

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1.	Amounts include forward starting swaps of $1.7 billion ranging up to four months from December 31, 2012.



	December 31, 2011
Interest Rate Swaps ⁽¹⁾	Notional Amount		Average Fixed Pay Rate		Average Receive Rate		Net Estimated Fair Value			Average Maturity (Years)
Three years or less	$	11,350	1.22	%	0.30	%	$	(148	)	2.1
Greater than 3 years and less than/equal to 5 years	16,700		1.77	%	0.35	%	(607		)	3.9
Greater than 5 years and less than/equal to 7 years	950		1.56	%	0.57	%	(9		)	5.7
Greater than 7 years and less than/equal to 10 years	1,250		1.99	%	0.55	%	(18		)	8.2
Total Payer Interest Rate Swaps	$	30,250	1.57	%	0.35	%	$	(782	)	3.5

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1.	Amounts include forward starting swaps of $2.6 billion ranging up to five months from December 31, 2011.

The following tables summarize our interest rate swaption agreements outstanding as of December 31, 2012 and 2011 (dollars in millions):



	December 31, 2012
	Option					Underlying Swap
Payer Swaptions	Cost		Fair Value		Average Months to Expiration	Notional Amount		Average Fixed Pay Rate		Average Receive Rate	Average Term (Years)
One year or less	$	76	$	15	4	$	5,150	2.65	%	1M / 3M LIBOR	8.6
Greater than 1 year and less than/equal to 2 years	65		34		19	$	4,050	2.82	%	3M LIBOR	6.7
Greater than 2 years and less than/equal to 3 years	97		87		33	$	3,900	3.51	%	3M LIBOR	8.6
Greater than 3 years and less than/equal to 4 years	12		11		46	$	450	3.20	%	3M LIBOR	6.1
Greater than 4 years and less than/equal to 5 years	24		24		59	$	900	3.33	%	3M LIBOR	5.0
Total/Wtd Avg	$	274	$171		21	$	14,450	2.99	%	1M / 3M LIBOR	7.8



	December 31, 2011
	Option					Underlying Swap
Payer Swaptions	Cost		Fair Value		Average Months to Expiration	Notional Amount		Average Fixed Pay Rate		Average Receive Rate	Average Term (Years)
One year or less	$	22	$	4	4	$	2,200	3.13	%	1M / 3M LIBOR	6.5
Greater than 1 year and less than/equal to 2 years	27		7		15	1,000		4.04	%	1M / 3M LIBOR	10.2
Total/Wtd Avg	$	49	$	11	7	$	3,200	3.41	%	1M / 3M LIBOR	7.7

The following table summarizes our contracts to purchase and sell TBA and specified agency securities on a forward basis as of December 31, 2012 and 2011 (in millions):



	December 31, 2012									December 31, 2011
Purchase and Sale Contracts for TBAs and Forward Settling Securities	Notional Amount			Forward Settlement Price			Net Fair Value			Notional Amount			Forward Settlement Price			Net Fair Value
TBA securities:
Purchase contracts	$	21,705		$	22,603		$	116		$	3,188		$	3,252		$	49
Sale contracts	(9,378		)	(9,991		)	(20		)	(3,803		)	(3,935		)	(41		)
TBA securities, net ⁽¹⁾	12,327			12,612			96			(615		)	(683		)	8
Forward settling securities:
Purchase contracts	150			163			(1		)	512			530			5
Forward settling securities, net ⁽²⁾	150			163			(1		)	512			530			5
Total TBA and forward settling securities, net	$	12,477		$	12,775		$	95		$	(103	)	$	(153	)	$	13

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1.	Includes 15-year and 30-year TBA securities of varying coupons


2.	Includes 20-year and 30-year fixed securities of varying coupons

Gain (Loss) From Derivative Instruments and Other Securities, Net

During fiscal year 2012, none of our derivative instruments were designated as hedges under ASC 815. The table below summarizes the effect of derivative instruments on our consolidated statements of comprehensive income for fiscal year 2012 (in millions):



	Fiscal Year 2012
Derivative and Other Hedging Instruments	Notional Amount as of December 31, 2011		Additions	Settlement, Termination, Expiration or Exercise		Notional Amount as of December 31, 2012		Amount of Gain/(Loss) Recognized in Income on Derivatives⁽¹⁾
Purchase of TBA and forward settling agency securities	$	3,700	140,731	(122,576	)	$	21,855	$	444
Sale of TBA and forward settling agency securities	$	3,803	176,905	(171,330	)	$	9,378	(413		)
Interest rate swaps	$	30,250	25,000	(8,400	)	$	46,850	(1,034		)
Payer swaptions	$	3,200	18,250	(7,000	)	$	14,450	(106		)
Short sales of U.S. Treasury securities	$	880	36,555	(25,600	)	$	11,835	(142		)
U.S. Treasury futures - short	$	783	3,838	(4,621	)	$	—	(90		)
Markit IOS total return swaps - long	$	41	—	(41	)	$	—	—
Markit IOS total return swaps - short	$	206	—	(206	)	$	—	—
								$	(1,341	)

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1.	Excludes a gain of $17 million from interest-only and principal-only securities, a loss of $1 million from U.S. Treasury securities and a loss of $28 million from debt of consolidated VIEs re-measured at fair value through earnings recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income.

During fiscal years 2011 and 2010, we held both designated and non-hedge designated derivative instruments under ASC 815.

The following tables summarize the effect of non-hedge designated derivative instruments on our consolidated statements of comprehensive income for fiscal years 2011 and 2010 (in millions):



	Fiscal Year 2011
Non Designated Derivative and Other Hedging Instruments	Notional Amount as of December 31, 2010		Additions	Additions Due to Hedge De-Designations	Settlement, Termination, Expiration or Exercise		Notional Amount as of December 31, 2011		Amount of Gain/(Loss) Recognized in Income on Derivatives⁽¹⁾
Purchase of TBA and forward settling agency securities	$	512	51,488	—	(48,300	)	$	3,700	$	160
Sale of TBA and forward settling agency securities	$	1,361	100,077	—	(97,635	)	$	3,803	(302		)
Interest rate swaps	$	50	6,750	23,900	(450	)	$	30,250	(119		)
Payer swaptions	$	850	5,600	—	(3,250	)	$	3,200	(63		)
Receiver swaptions	$	—	250	—	(250	)	$	—	(1		)
Short sales of U.S. Treasury securities	$	250	15,794	—	(15,164	)	$	880	(133		)
US Treasury futures - long	$	—	50	—	(50	)	$	—	—
US Treasury futures - short	$	—	1,133	—	(350	)	$	783	(12		)
Put options	$	—	200	—	(200	)	$	—	1
Markit IOS total return swaps - long	$	—	1,195	—	(1,154	)	$	41	(7		)
Markit IOS total return swaps - short	$	—	685	—	(479	)	$	206	14
									$	(462	)

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1.	Excludes a loss of $17 million from interest-only and principal-only securities re-measured at fair value through earnings, a loss of $2 million for hedge ineffectiveness on our outstanding interest rate swaps and a gain of $34 million from U.S. Treasury securities in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income.



	Fiscal Year 2010
Non Designated Derivative and Other Hedging Instruments	Notional Amount as of December 31, 2009		Additions	Settlement, Termination, Expiration or Exercise		Notional Amount as of December 31, 2010		Amount of Gain/(Loss) Recognized in Income on Derivatives⁽¹⁾
Purchase of TBA and forward settling agency securities	$	597	6,662	(6,747	)	$	512	$	19
Sale of TBA and forward settling agency securities	$	617	16,937	(16,193	)	$	1,361	11
Interest rate swaps	$	—	350	(300	)	$	50	(3		)
Payer swaptions	$	200	850	(200	)	$	850	19
Receiver swaptions	$	100	300	(400	)	$	—	—
Short sales of U.S. Treasury securities	$	—	750	(500	)	$	250	(2		)
Put options	$	—	75	(75	)	$	—	—
								$	44

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1.	Excludes a loss of $1 million from interest-only and principal-only securities re-measured at fair value through earnings and a loss of $5 million from U.S. Treasury securities in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income for the year ended December 31, 2010.

The following tables summarize information about our outstanding interest rate swaps designated as hedging instruments under ASC 815 and their effect on our consolidated statement of comprehensive income for fiscal years 2011 and 2010 (in millions):



Interest Rate Swaps Designated as Hedging Instruments	Beginning Notional Amount		Additions	Expirations / Terminations		Hedge De-Designations		Ending Notional Amount
Fiscal year 2011	$	6,450	17,900	(450	)	(23,900	)	$	—
Fiscal year 2010	$	2,050	4,400	—		—		$	6,450



Interest Rate Swaps Designated as Hedging Instruments:	Amount of Gain or (Loss) Recognized in OCI (Effective Portion)			Location of Gain or (Loss) Reclassified from OCI into Earnings (Effective Portion)	Amount of (Gain) or Loss Reclassified from OCI into Earnings (Effective Portion)			Location of Gain or (Loss) Recognized in Earnings (Ineffective Portion and Amount Excluded from Effectiveness Testing)	Amount of Gain or (Loss) Recognized in Earnings (Ineffective Portion and Amount Excluded from Effectiveness Testing)
Fiscal year 2011	$	(707	)	Interest expense	$	(140	)	Gain (loss) on derivative instruments and other securities, net	$	(2	)
Fiscal year 2010	$	(21	)	Interest expense	$	(57	)	Gain (loss) on derivative instruments and other securities, net	$	—

During fiscal years 2011 and 2010, we also held forward contracts to purchase TBA and specified agency securities that were designated as cash flow hedges under to ASC 815. The following tables summarize information about these securities and their effect on our consolidated statement of comprehensive income for fiscal years 2011 and 2010 (dollars in millions):



Purchases of TBAs and Forward Settling Agency Securities Designated as Hedging Instruments	Beginning Notional Amount		Additions		Settlement / Expirations			Ending Notional Amount		Fair Value as of Period End			Average Maturity as of Period End (Months)
Fiscal year 2011	$	245	$	—	$	(245	)	$	—	$	—		—
Fiscal year 2010	$	—	$	742	$	(497	)	$	245	$	(3	)	1



Purchases of TBAs and Forward Settling Agency Securities Designated as Hedging Instruments	Amount of Gain or (Loss) Recognized in OCI for Cash Flow Hedges (Effective Portion)			Amount of (Gain) or Loss Recognized in OCI for Cash Flow Hedges and Reclassified to OCI for Available-for-Sale Securities (Effective Portion)			Location of Gain or (Loss) Recognized in Earnings (Ineffective Portion and Amount Excluded from Effectiveness Testing)	Amount of Gain or (Loss) Recognized in Earnings (Ineffective Portion and Amount Excluded from Effectiveness Testing)
Fiscal year 2011	$	—		$	(3	)	Gain (loss) on derivative instruments and other securities, net	$	—
Fiscal year 2010	$	(3	)	$	(3	)	Gain (loss) on derivative instruments and other securities, net	$	—

Credit Risk-Related Contingent Features

The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings and monitoring positions with individual counterparties. In addition, we may be required to pledge assets as collateral for our derivatives, whose amounts vary over time based on the market value, notional amount and remaining term of the derivative contract. In the event of a default by a counterparty we may not receive payments provided for under the terms of our derivative agreements, and may have difficulty obtaining our assets pledged as collateral for our derivatives. The cash and cash equivalents and agency securities pledged as collateral for our derivative instruments is included in restricted cash and agency securities, respectively, on our consolidated balance sheets.

Each of our International Swaps and Derivatives Association ("ISDA") Master Agreements contains provisions under which we are required to fully collateralize our obligations under the swap instrument if at any point the fair value of the swap represents a liability greater than the minimum transfer amount contained within our agreements. We were also required to post initial collateral upon execution of certain of our swap transactions. If we breach any of these provisions, we will be required to settle our obligations under the agreements at their termination values.

Further, each of our ISDA Master Agreements also contains a cross default provision under which a default under certain of our other indebtedness in excess of a certain threshold causes an event of default under the agreement. Threshold amounts vary by lender. Following an event of default, we could be required to settle our obligations under the agreements at their termination values. Additionally, under certain of our ISDA Master Agreements, we could be required to settle our obligations under the agreements at their termination values if we fail to maintain certain minimum shareholders’ equity thresholds or our REIT status or if we fail to comply with limits on our leverage above certain specified levels.

As of December 31, 2012, the fair value and termination value of our interest rate swaps in a liability position related to these agreements was $1.2 billion. We had agency securities with fair values of $1.1 billion and restricted cash of $249 million pledged as collateral against our interest rate swap agreements.