Derivatives and Hedging Activity

6 Months Ended

Jun. 30, 2014

Derivatives and Hedging Activity

Derivatives and Hedging Activity

11. Derivatives and Hedging Activity

Risk Management Objective of Using Derivatives

We are exposed to certain risks arising from both our business operations and economic conditions. Refer to Note 13 to the consolidated financial statements included in our Form 10-K for further discussion of our risk management objectives and policies.

Designated Hedges

Our objective in using interest rate derivatives is to manage our exposure to interest rate movements. To accomplish this objective, we primarily use interest rate swaps as part of our interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for us making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

In connection with our repurchase agreements, we have entered into seven outstanding interest rate swaps that have been designated as cash flow hedges of the interest rate risk associated with forecasted interest payments. As of June 30, 2014, the aggregate notional amount of our interest rate swaps designated as cash flow hedges of interest rate risk totaled $162.9 million. Under these agreements, we will pay fixed monthly coupons at fixed rates ranging from 0.56% to 2.23% of the notional amount to the counterparty and receive floating rate LIBOR. Our interest rate swaps designated as cash flow hedges of interest rate risk have maturities ranging from November 2015 to May 2021.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in AOCI and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and six months ended June 30, 2014 and 2013 we did not recognize any hedge ineffectiveness in earnings.

Amounts reported in AOCI related to derivatives will be reclassified to interest expense as interest payments are made on the associated variable-rate debt. Over the next twelve months, we estimate that an additional $1.0 million will be reclassified as an increase to interest expense. We are hedging our exposure to the variability in future cash flows for forecasted transactions over a maximum period of 83 months.

Non-designated Hedges

Derivatives not designated as hedges are derivatives that do not meet the criteria for hedge accounting under GAAP or which we have not elected to designate as hedges. We do not use these derivatives for speculative purposes but instead they are used to manage our exposure to foreign exchange rates, interest rate changes, and certain credit spreads. Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in gain (loss) on derivative financial instruments in our condensed consolidated statements of operations. The LNR conduit platform uses interest rate and credit index instruments to manage exposures related to commercial mortgage loans held-for-sale.

We have entered into a series of forward contracts whereby we agreed to sell an amount of foreign currency for an agreed upon amount of USD at various dates through January 2018. These forward contracts were executed to economically fix the USD amounts of foreign denominated cash flows expected to be received by us related to foreign denominated loan investments.

As of June 30, 2014, we had 66 foreign exchange forward derivatives to sell pounds sterling (“GBP”) with a total notional amount of £226.2 million, 29 foreign exchange forward derivatives to sell Euros (“EUR”) with a total notional amount of €147.9 million, two foreign exchange forward derivatives to sell Swedish Krona (“SEK”) with a total notional of SEK 23.0 million, one foreign exchange forward derivative to sell Norwegian Krone (“NOK”) with a notional of NOK 1.3 million and one foreign exchange forward to sell Danish Krone (“DKK”) with a notional of DKK 3.2 million that were not designated as hedges in qualifying hedging relationships.  We also had one foreign exchange forward contract to buy EUR with a total notional of €60.3 million.  As of June 30, 2014, there were 34 interest rate swaps where the Company is paying fixed rates, with maturities ranging from 2 to 10 years and a total notional amount of $203.1 million, four interest rate swaps where the Company is receiving fixed rates with maturities ranging from 0 to 3 years and a total notional of $59.9 million and eight credit index instruments with a total notional amount of $50.0 million.  The table below presents the fair value of our derivative financial instruments as well as their classification on the condensed consolidated balance sheets as of June 30, 2014 and December 31, 2013 (amounts in thousands):

	Fair Value of Derivatives in an Asset Position(1) As of				Fair Value of Derivatives in a Liability Position(2) As of
	June 30, 2014		December 31, 2013		June 30, 2014		December 31, 2013
Derivatives designated as hedging instruments:
Interest rate swaps	$	63	$	125	$	638	$	729
Total derivatives designated as hedging instruments	63		125		638		729
Derivatives not designated as hedging instruments:
Interest rate swaps	1,874		5,102		1,819		983
Foreign exchange contracts	502		269		23,837		22,480
Credit index instruments	2,242		2,273		—		—
Total derivatives not designated as hedging instruments	4,618		7,644		25,656		23,463
Total derivatives	$	4,681	$	7,769	$	26,294	$	24,192

(1) Classified as derivative assets in our condensed consolidated balance sheets.

(2) Classified as derivative liabilities in our condensed consolidated balance sheets.

The tables below present the effect of our derivative financial instruments on the condensed consolidated statements of operations and of comprehensive income for the three and six months ended June 30, 2014 and 2013:

Derivatives Designated as Hedging Instruments For the Three Months Ended June 30,	(Loss) Gain Recognized in OCI (effective portion)			(Loss) Gain Reclassified from AOCI into Income (effective portion)			(Loss) Gain Recognized in Income (ineffective portion)		Location of (Loss) Gain Recognized in Income
2014	$	(457	)	$	(364	)	$	—	Interest expense
2013	$	1,094		$	(407	)	$	—	Interest expense
For the Six Months Ended June 30,
2014	$	(708	)	$	(737	)	$	—	Interest expense
2013	$	926		$	(854	)	$	—	Interest expense

Derivatives Not Designated as	Location of (Loss) Gain	Amount of (Loss) Gain Recognized in Income for theThree Months Ended June 30,						Amount of (Loss) Gain Recognized in Income for theSix Months Ended June 30,
Hedging Instruments	Recognized in Income	2014			2013			2014			2013
Interest rate swaps	(Loss) gain on derivative financial instruments	$	(2,314	)	$	6,863		$	(6,511	)	$	7,013
Foreign exchange contracts	(Loss) gain on derivative financial instruments	(6,965		)	(1,311		)	(10,012		)	14,767
Credit index instruments	(Loss) gain on derivative financial instruments	(511		)	606			(1,133		)	606
		$	(9,790	)	$	6,158		$	(17,656	)	$	22,386

Credit-risk-related Contingent Features

We have entered into agreements with certain of our derivative counterparties that contain provisions providing that if we were to default on any of our indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, we may also be declared in default on our derivative obligations. We also have certain agreements that contain provisions providing that if our ratio of principal amount of indebtedness to total assets at any time exceeds 75%, then we could be declared in default of our derivative obligations.

As of June 30, 2014, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk related to these agreements, was $24.5 million. As of June 30, 2014, we had posted collateral of $19.1 million related to these agreements. If we had breached any of these provisions at June 30, 2014, we could have been required to settle our obligations under the agreements at their termination liability value of $24.5 million.