NOTE 7 - DERIVATIVE INSTRUMENTS HEDGING AND NON-HEDGING ACTIVITIES

The Company enters into a variety of derivative instruments in connection with its risk management activities. The Company's primary objective for executing these derivatives and non-derivative instruments is to mitigate the Company's economic exposure to future events that are outside its control. The Company's derivative financial instruments are utilized principally to manage market risk and cash flow volatility associated with interest rate risk (including associated prepayment risk) related to certain assets and liabilities. As part of its risk management activities, the Company may, at times, enter into various forward contracts, including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps and caps. In executing on the Company's current risk management strategy, the Company has entered into interest rate swap and swaption agreements. Amounts receivable and payable under interest rate swap agreements are accounted for as unrealized gain (loss) on interest rate swap and swaption agreements, net in the condensed consolidated statement of operations. Premiums on swaptions are amortized on a straight line basis between trade date and expiration date and are recognized in the condensed consolidated statement of operations as a realized loss on swaption agreements. In addition, as set out in Note 3, the Company records Linked Transactions as a forward purchase (derivative) contract at fair value on the balance sheet. Although Linked Transactions are accounted for as derivative instruments, they are not entered into as part of the Company’s risk management activities and are not designated as hedging instruments.

The following summarizes the Company's significant asset and liability derivatives, the risk exposure for these derivatives and the Company's risk management activities used to mitigate certain of these risks. While the Company uses derivative instruments to achieve the Company's risk management activities, it is possible that these instruments will not effectively mitigate all or a substantial portion of the Company's market rate risk. In addition, the Company might elect, at times, not to enter into certain hedging arrangements in order to maintain compliance with REIT requirements.

Balance Sheet Presentation

The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments as of June 30, 2013 and December 31, 2012. The Company’s Linked Transactions are evaluated on a combined basis.

	June 30, 2013
	Derivative Assets				Derivative Liabilities
	Fair value		Notional		Fair value		Notional
Interest rate swaps	$	5,770,974		485,000,000	$	-		-
Swaptions		1,618,567		25,000,000		-		-
Linked transactions		15,657,200		-		-		-
Total	$	23,046,741		510,000,000	$	-		-

	December 31, 2012
	Derivative Assets				Derivative Liabilities
	Fair value		Notional		Fair value			Notional
Interest rate swaps	$	-		-	$	(283,754	)		35,000,000
Swaptions		12,062		5,000,000		-			-
Linked transactions		8,612,753		-		-			-
Total	$	8,624,815		5,000,000	$	(283,754	)		35,000,000

The following tables present the average fixed pay rate and average maturity for the Company’s interest rate swaps (excludes interest rate swaptions) as of June 30, 2013 and December 31, 2012:

	June 30, 2013
	Notional		Fair			Fixed Pay			Maturity		Forward
Current Maturity Date	Amount		Value			Rate			Years		Starting
3 years or less	$	135,000,000	$	388,972			0.56	%		2.8		0.0	%
Greater than 5 years and less than 7 years		100,000,000		(678,652	)		1.69	%		5.1		0.0	%
Greater than 7 years and less than 10 years		150,000,000		2,864,274			2.34	%		8.1		100.0	%
Greater than 10 years		100,000,000		3,196,380			2.71	%		11.1		100.0	%
Total	$	485,000,000	$	5,770,974			1.79	%		6.6		51.5	%

	December 31, 2012
	Notional		Fair			Fixed Pay			Maturity		Forward
Current Maturity Date	Amount		Value			Rate			Years		Starting
3 years or less	$	15,000,000	$	(53,437	)		0.51	%		2.6		0.0	%
Greater than 3 years and less than 5 years		20,000,000		(230,317	)		0.78	%		3.5		0.0	%
Total	$	35,000,000	$	(283,754	)		0.66	%		3.1		0.0	%

Offsetting of Financial Assets and Liabilities

The Company has offset certain financial assets and liabilities in the condensed consolidated balance sheet under FASB guidance ASC 210 and ASC 815. The below table provides a reconciliation of these assets and liabilities that were offset as of June 30, 2013 and December 31, 2012:

	June 30, 2013
	Gross amounts		Gross amounts			Net amounts
	of recognized		offset in the			of assets presented
Description	assets		Balance Sheet			in the Balance Sheet
Linked transactions⁽¹⁾	$	46,008,881	$	(30,351,681	)	$	15,657,200
Interest rate swaps		6,527,414		(756,440	)		5,770,974
Swaptions		1,618,567		-			1,618,567
Total	$	54,154,862	$	(31,108,121	)	$	23,046,741

	June 30, 2013
	Gross amounts			Gross amounts		Net amounts
	of recognized			offset in the		of liabilities presented
Description	liabilities			Balance Sheet		in the Balance Sheet
Interest rate swaps	$	(756,440	)	$	756,440	$	-
Total	$	(756,440	)	$	756,440	$	-

	December 31, 2012
	Gross amounts		Gross amounts			Net amounts
	of recognized		offset in the			of assets presented
Description	assets		Balance Sheet			in the Balance Sheet
Linked transactions⁽¹⁾	$	22,636,490	$	(14,023,737	)	$	8,612,753
Swaptions		12,062		-			12,062
Total	$	22,648,552	$	(14,023,737	)	$	8,624,815

	December 31, 2012
	Gross amounts			Gross amounts		Net amounts
	of recognized			offset in the		of liabilities presented
Description	liabilities			Balance Sheet		in the Balance Sheet
Interest rate swaps	$	(283,754	)	$	-	$	(283,754	)
Total	$	(283,754	)	$	-	$	(283,754	)

(1) RMBS securities within a linked transaction serve as collateral for the linked transaction. See Note 3 “Non-Hedging Activity – Linked Transactions” for information on linked transaction arrangements.

The Company has in place with its counterparties ISDA Master Agreements (“Master Agreements”) for its derivative contracts. In accordance with the Master Agreements to each counterparty, if on any date amounts would otherwise be payable in the same currency and in respect of the same transaction by each party to the other, then, on such date, each party’s obligation to make payment of any such amount will be automatically satisfied and discharged and, if the aggregate amount that would otherwise have been payable by one party exceeds the aggregate amount that would otherwise have been payable by the other party, replaced by an obligation upon the party by whom the larger aggregate amount would have been payable to pay to the other party the excess of the larger aggregate amount over the smaller aggregate amount.

The Company has pledged financial collateral as restricted cash to its counterparties for its derivative contracts. See Note 2 for specific details on the terms of restricted cash with counterparties and Note 5 for the amounts of restricted cash outstanding.

Linked Transactions

The Company’s Linked Transactions are accounted for on a net basis and recorded as forward purchase (derivative) contracts at fair value on the Company’s condensed consolidated balance sheet. The fair value of Linked Transactions reflects the value of the underlying Non-Agency RMBS, the linked repurchase borrowings and accrued interest receivable/payable on such instruments. The Company’s Linked Transactions are not designated as hedging instruments and, as a result, the change in fair value and net interest income is reported as “Unrealized gain (loss) and net interest income from Linked Transactions” in other income on the Company’s condensed consolidated statement of operations.

The following tables present certain information concerning the Non-Agency RMBS and repurchase financings underlying the Company’s Linked Transactions as of June 30, 2013 and December 31, 2012:

Linked Non-Agency RMBS

	June 30, 2013			December 31, 2012
Face Value	$	75,660,274		$	38,320,365
Unamortized premium		-			-
Unamortized discount
Designated credit reserve		(18,628,510	)		(12,929,231	)
Net, unamortized		(14,379,599	)		(6,721,749	)
Amortized Cost		42,652,165			18,669,385
Gross unrealized gains		3,336,274			3,950,157
Fair Value	$	45,988,439		$	22,619,542

The following tables present the changes for the six months ended June 30, 2013 and for the period May 16, 2012 (commencement of operations) to December 31, 2012 of the unamortized net discount and designated credit reserves on Non-Agency RMBS underlying Linked Transactions:

	June 30, 2013
	Designated			Unamortized
	credit reserve			net discount			Total
Acquisitions	$	(20,416,766	)	$	(15,295,000	)	$	(35,711,766	)
Accretion of net discount		-			915,401			915,401
Realized credit losses		1,788,256			-			1,788,256
Ending balance at June 30, 2013	$	(18,628,510	)	$	(14,379,599	)	$	(33,008,109	)

	December 31, 2012
	Designated			Unamortized
	credit reserve			net discount			Total
Acquisitions	$	(13,934,657	)	$	(7,592,017	)	$	(21,526,674	)
Accretion of net discount		-			870,268			870,268
Realized credit losses		1,005,426			-			1,005,426
Ending balance at December 31, 2012	$	(12,929,231	)	$	(6,721,749	)	$	(19,650,980	)

Linked Repurchase Agreements

	June 30, 2013
	Amount		Percent of total			Weighted average		Company RMBS
Repurchase Agreement Counterparties	Outstanding		amount outstanding			days to maturity		held as collateral
North America	$	26,156,000		86.29	%		36	$	38,938,632
Asia ⁽¹⁾		4,154,000		13.71	%		8		7,049,807
Total	$	30,310,000		100.00	%		32	$	45,988,439

(1) Counterparties domiciled in Europe and Asia, or their U.S. subsidiaries.

	December 31, 2012
	Amount		Percent of total			Weighted average		Company RMBS
Repurchase Agreement Counterparties	Outstanding		amount outstanding			days to maturity		held as collateral
North America	$	9,277,000		66.32	%		41	$	13,714,701
Asia ⁽¹⁾		4,712,000		33.68	%		12		8,904,841
Total	$	13,989,000		100.00	%		31	$	22,619,542

(1) Counterparties domiciled in Europe and Asia, or their U.S. subsidiaries.

At June 30, 2013, Linked Transactions also included $20,442 of associated accrued interest receivable and $41,681 of accrued interest payable.

Income Statement Presentation

The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt portfolio. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its interest rate swaps, swaptions and any other derivative instruments.

The following table summarizes the underlying hedged risks and the amount of gains and losses on derivative instruments reported net in the condensed consolidated statement of operations as realized gain (loss) on swap and swaption agreements and unrealized gain (loss) on interest rate swap and swaption agreements for the three and six months ended June 30, 2013 and the period May 16, 2012 (commencement of operations) to June 30, 2012:

	Three Months Ended June 30, 2013
	Amount of realized			Amount of unrealized
Primary underlying risk	gain (loss)			appreciation (depreciation)		Total

Interest rate:
Interest rate swaps	$	11,231,520		$	6,582,257	$	17,813,777
Swaptions		(94,667	)		1,038,635		943,968
TBAs		-			-		-
Total	$	11,136,853		$	7,620,892	$	18,757,745

	Six Months Ended June 30, 2013
	Amount of realized			Amount of unrealized
Primary underlying risk	gain (loss)			appreciation (depreciation)		Total

Interest rate:
Interest rate swaps	$	11,176,200		$	6,054,728	$	17,230,928
Swaptions		(110,667	)		1,045,172		934,505
Total	$	11,065,533		$	7,099,900	$	18,165,433

	Period May 16, 2012 to June 30, 2012
	Amount of realized			Amount of unrealized
Primary underlying risk	gain (loss)			appreciation (depreciation)			Total

Interest rate:
Interest rate swaps	$	-		$	(231,609	)	$	(231,609	)
Swaptions		(5,333	)		(2,521	)		(7,854	)
Total	$	(5,333	)	$	(234,130	)	$	(239,463	)

The following table presents certain information about the components of the unrealized net gain (loss) and net interest income from Linked Transactions included in the Company’s condensed consolidated statement of operations for the three and six months ended June 30, 2013 and the period May 16, 2012 (commencement of operations) to June 30, 2012:

	Three Months Ended			Six Months Ended
	June 30, 2013			June 30, 2013
Interest income attributable to RMBS underlying Linked Transactions	$	612,903		$	1,064,756
Interest expense attributable to linked repurchase agreement borrowings underlying Linked Transactions		(112,752	)		(184,055	)
Change in fair value of Linked Transactions included in earnings		(1,987,175	)		(613,883	)
Unrealized gain (loss) and net interest income from Linked Transactions	$	(1,487,024	)	$	266,818

	Period May 16, 2012
	to June 30, 2012
Interest income attributable to RMBS underlying Linked Transactions	$	54,821
Interest expense attributable to linked repurchase agreement borrowings underlying Linked Transactions		(14,839	)
Change in fair value of Linked Transactions included in earnings		137,481
Unrealized gain and net interest income from Linked Transactions	$	177,463