Derivative Financial Instruments

9 Months Ended

Sep. 30, 2014

Derivative Financial Instruments [Abstract]

Derivative Financial Instruments

NOTE 4. DERIVATIVE FINANCIAL INSTRUMENTS

In connection with its interest rate risk management strategy, the Company economically hedges a portion of the cost of its repurchase agreement funding by entering into derivatives, such as Eurodollar and T-Note futures contracts and interest rate swaptions.  The Company has not elected hedging treatment under GAAP, and as such all gains or losses (realized and unrealized) on these instruments are reflected in earnings for all periods presented.

As of December 31, 2013, such instruments were comprised entirely of Eurodollar futures contracts. During the nine months ended September 30, 2014, the Company entered into, and settled before the end of the quarter, a T-Note futures contract. Eurodollar and T-Note futures are cash settled futures contracts on an interest rate, with gains or losses credited or charged to the Company’s account on a daily basis and reflected in earnings as they occur. A minimum balance, or “margin”, is required to be maintained in the account on a daily basis. This margin represents the collateral the Company has posted for its open positions and is recorded on the balance sheet as part of restricted cash. The Company is exposed to the changes in value of the futures by the amount of margin held by the broker.

During the nine months ended September 30, 2014, the Company was a party to interest rate swaption agreements. At September 30, 2014, the Company had outstanding swaption agreements which grant the Company the right but not the obligation to enter into underlying pay fixed interest rate swap (“payer swaption”). The Company may also enter into swaption agreements that provide the Company the option to enter into receive fixed interest rate swap (“receiver swaption”).

Derivative Assets (Liability), at Fair Value

The table below summarizes fair value information about our derivative assets and liability as of September 30, 2014 and December 31, 2013.

(in thousands)
Derivative Instruments and Related Accounts	Balance Sheet Location	September 30, 2014		December 31, 2013
Assets
Eurodollar futures - Margin posted to counterparty	Restricted cash	$	3,000	$	2,446
Payer swaptions	Derivative assets, at fair value		3,906		-
		$	6,906	$	2,446
Liability
Payer swaptions - Margin posted by counterparty	Other liabilities	$	(3,776)	$	-

The tables below present information related to the Company’s Eurodollar futures positions at September 30, 2014 and December 31, 2013.

($ in thousands)
	September 30, 2014					December 31, 2013
			Average					Average
	Weighted		Contract			Weighted		Contract
	Average		Notional		Open	Average		Notional		Open
Expiration Year	LIBOR Rate		Amount		Equity(1)	LIBOR Rate		Amount		Equity(1)
2014	-	$	-	$	-	0.40%	$	262,500	$	(189)
2015	0.74%		550,000		(329)	0.80%		275,000		(146)
2016	1.76%		550,000		1,379	1.90%		250,000		1,367
2017	2.68%		400,000		1,067	3.03%		250,000		2,291
2018	3.07%		400,000		(177)	3.77%		250,000		1,575
Total / Weighted Average	1.87%	$	480,000	$	1,940	2.02%	$	257,353	$	4,898

Open equity represents the cumulative gains (losses) recorded on open futures positions from inception.

The table below presents information related to the Company’s interest rate swaption positions at September 30, 2014.

($ in thousands)
	Option					Underlying Swap
					Weighted					Weighted
					Average			Fixed	Receive	Average
				Fair	Months to		Notional	Pay	Rate	Term
Expiration		Cost		Value	Expiration		Amount	Rate	(LIBOR)	(Years)
≤ 1 year	$	4,720	$	3,906	10	$	275,000	2.96%	3 Month	8.2

Gain (Loss) From Derivative Instruments, Net

The table below presents the effect of the Company’s derivative financial instruments on the statements of operations for thenine and three months ended September 30, 2014 and 2013.

(in thousands)
		Nine Months Ended September 30,				Three Months Ended September 30,
		2014		2013		2014		2013
Eurodollar futures contracts (short positions)	$	(3,316)	$	4,096	$	2,820	$	(2,272)
T-Note futures contract (short position)		72		-		72		-
Payer swaptions		(1,120)		-		166		-
	$	(4,364)	$	4,096	$	3,058	$	(2,272)

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 for instruments which are not centrally cleared on a registered exchange 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 pledged as collateral for our derivative instruments are included in restricted cash on our balance sheets.