USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

9 Months Ended

Sep. 30, 2013

USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT [Abstract]

USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

NOTE 7 ¾ USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

To help mitigate exposure to higher interest rates, Capstead typically uses currently-paying and forward-starting, one-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements that require interest payments for two-year terms.  These Derivatives are designated as cash flow hedges of the variability of the underlying benchmark interest rate of current and forecasted 30- to 90-day borrowings under repurchase arrangements.  This hedge relationship establishes a relatively stable fixed rate on related borrowings because the variable-rate payments received on the swap agreements offset a significant portion of the interest accruing on the related borrowings, leaving the fixed-rate payments to be paid on the swap agreements as the Company’s effective borrowing rate, subject to certain adjustments.  These adjustments include changes in spreads between variable rates on the swap agreements and actual borrowing rates as well as the effects of measured hedge ineffectiveness.  Additionally, changes in fair value of these Derivatives tend to partially offset opposing changes in fair value of the Company’s residential mortgage investments that can occur in response to changes in market interest rates.

During the quarter and nine months ended September 30, 2013 Capstead entered into new forward-starting swap agreements with notional amounts of $700 million and $2.60 billion, respectively.  These swap agreements require fixed rate interest payments averaging 0.58% and 0.50%, respectively, for two-year periods that commence on various dates between December 2013 and April 2014.  Swap agreements with notional amounts totaling $300 million and $2.10 billion requiring fixed rate interest payments each averaging 0.87%, respectively, expired during the quarter and nine months ended September 30, 2013.  At September 30, 2013, the Company’s portfolio financing-related swap positions had the following characteristics (dollars in thousands):

Period of Contract Expiration	Notional Amount		Average Fixed Rate Payment Requirement
Currently-paying contracts:
Fourth quarter 2013	$	800,000		0.78	%
First quarter 2014		200,000		0.60
Second quarter 2014		400,000		0.51
Third quarter 2014		200,000		0.51
Fourth quarter 2014		500,000		0.58
First quarter 2015		1,100,000		0.50
Second quarter 2015		200,000		0.43
Third quarter 2015		400,000		0.47
(average expiration:  11 months)		3,800,000		0.57
Forward-starting contracts:
Fourth quarter 2015		1,200,000		0.45
First quarter 2016		1,700,000		0.51
Second quarter 2016		400,000		0.45
(average expiration:  27 months)		3,300,000		0.48
(average expiration:  18 months)	$	7,100,000

In addition to portfolio financing-related swap positions, in 2010 the Company entered into three forward-starting, three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements with notional amounts totaling $100 million, average fixed rates of 4.09% that begin in 2015 and 2016, and 20-year payment terms coinciding with the floating-rate terms of the Company’s Unsecured borrowings.  These Derivatives are designated as cash flow hedges of the variability of the underlying benchmark interest rate associated with the floating-rate terms of these long-term borrowings (see NOTE 8).

Interest rate swap agreements are measured at fair value on a recurring basis primarily using Level Two Inputs in accordance with “Fair Value Measurements and Disclosures” (“ASC 820”).  In determining fair value estimates for these Derivatives, the Company utilizes the standard methodology of netting the discounted future fixed cash payments and the discounted future variable cash receipts which are based on expected future interest rates derived from observable market interest rate curves.  The Company also incorporates both its own nonperformance risk and its counterparties’ nonperformance risk in determining the fair value of these Derivatives.  In considering the effect of nonperformance risk, the Company considered the impact of netting and credit enhancements, such as collateral postings and guarantees, and has concluded that counterparty risk is not significant to the overall valuation of these agreements.

The following tables include fair value and other related disclosures regarding all Derivatives held as of and for the indicated periods (in thousands):

	Balance Sheet	September 30,			December 31,
	Location	2013			2012
Balance sheet-related
Interest rate swap agreements in a gain position (an asset) related to borrowings under repurchase arrangements	(a)	$	1,558		$	169
Interest rate swap agreements in a loss position (a liability) related to:
Borrowings under repurchase arrangements	(a)		(10,858	)		(18,671	)
Unsecured borrowings	(a)		(567	)		(14,197	)
Related net interest payable	(b)		(6,356	)		(7,788	)
		$	(16,223	)	$	(40,487	)

(a) The fair value of Derivatives with realized and unrealized gains are aggregated and recorded as an asset on the face of the Balance Sheet separately from the fair value of Derivatives with realized and unrealized losses that are recorded as a liability.  The amount of unrealized losses at September 30, 2013 scheduled to be recognized in the Statement of Income over the next twelve months primarily in the form of fixed-rate swap payments in excess of current market rates totaled $13.4 million.

(b) Included in “Accounts payable and accrued expenses” on the face of the Balance Sheet.

	Location of Gain or (Loss) Recognized in	Quarter Ended September 30						Nine Months Ended September 30, 2013
	Net Income	2013			2012			2013			2012
Income statement-related
Components of effect on interest expense:
Amount of loss reclassified from Accumulated other comprehensive income related to the effective portion of active positions		$	(3,698	)	$	(4,835	)	$	(13,548	)	$	(14,630	)
Amount of gain (loss) recognized (ineffective portion)			(23	)		211			73			(96	)
Increase in interest expense and decrease in Net income as a result of the use of Derivatives	(a)	$	(3,721	)	$	(4,624	)	$	(13,475	)	$	(14,726	)
Other comprehensive income-related
Amount of gain (loss) recognized in Other comprehensive income (loss) (effective portion)		$	(10,867	)	$	(8,454	)	$	9,136		$	(25,539	)

(a) Included in “Interest expense:  Repurchase arrangements and similar borrowings” on the face of the Statement of Income.

The Company’s swap agreements and borrowings under repurchase arrangements are subject to master netting arrangements in the event of default on, or termination of, any one contract.  See NOTE 6 for more information on the Company’s use of repurchase arrangements.  The following tables provide disclosures concerning offsetting of financial liabilities and Derivatives as of the indicated dates (in thousands):

	Offsetting of Derivative Assets
			Gross		Net Amounts		Gross Amounts Not Offset
	Gross		Amounts		of Assets		in the Balance Sheet
	Amounts of		Offset in		Presented in					Cash
	Recognized		the Balance		the Balance		Financial			Collateral		Net
	Assets		Sheet		Sheet		Instruments			Received		Amount
As of September 30, 2013:
Counterparty 1	$	463	$	–	$	463	$	(463	)	$	–	$	–
Counterparty 2		1,095		–		1,095		(1,095	)		–		–
	$	1,558	$	–	$	1,558	$	(1,558	)	$	–	$	–
As of December 31, 2012:
Counterparty 1	$	128	$	–	$	128	$	(128	)	$	–	$	–
Counterparty 2		41		–		41		(41	)		–		–
	$	169	$	–	$	169	$	(169	)	$	–	$	–

	Offsetting of Financial Liabilities and Derivative Liabilities
			Gross		Net Amounts		Gross Amounts Not Offset
	Gross		Amounts		of Liabilities		in the Balance Sheet (b)
	Amounts of		Offset in		Presented in					Cash
	Recognized		the Balance		the Balance		Financial			Collateral			Net
	Liabilities(a)		Sheet		Sheet (a)		Instruments			Pledged			Amount
As of September 30, 2013:
Derivatives by counterparty:
Counterparty 1	$	8,930	$	–	$	8,930	$	(463	)	$	(8,467	)	$	–
Counterparty 2		7,547		–		7,547		(1,095	)		(6,452	)		–
Counterparty 3		1,304		–		1,304		–			(1,304	)		–
		17,781		–		17,781		(1,558	)		(16,223	)		–
Repurchase arrangements and similar borrowings		12,621,015		–		12,621,015		(12,621,015	)		–			–
	$	12,638,796	$	–	$	12,638,796	$	(12,622,573	)	$	(16,223	)	$	–
As of December 31, 2012:
Derivatives by counterparty:
Counterparty 1	$	26,904	$	–	$	26,904	$	(128	)	$	(26,776	)	$	–
Counterparty 2		12,357		–		12,357		(41	)		(11,500	)		816
Counterparty 3		1,395		–		1,395		–			(1,395	)		–
		40,656		–		40,656		(169	)		(39,671	)		816
Repurchase arrangements and similar borrowings		12,791,243		–		12,791,243		(12,791,243	)		–			–
	$	12,831,899	$	–	$	12,831,899	$	(12,791,412	)	$	(39,671	)	$	816

(a) Amounts include accrued interest of $6.4 million and $7.8 million on interest rate swap agreements and $2.4 million and $7.0 million on repurchase arrangements and similar borrowings, included in “Accounts payable and accrued expenses” on the face of the Balance Sheets as of September 30, 2013 and December 31, 2012, respectively.

(b) Amounts presented are limited to collateral pledged sufficient to reduce the related Net Amount to zero in accordance with ASU No. 2011-11, as amended by ASU No. 2013-01.

Changes in Accumulated other comprehensive income by component for the quarter and nine months ended September 30, 2013 were as follows (in thousands):

	Gains and Losses on Cash Flow Hedges			Unrealized Gains and Losses on Available-for-Sale Securities			Total
Balance at June 30, 2013	$	(2,686	)	$	249,951		$	247,265
Activity for the quarter ended September 30, 2013:
Other comprehensive income (loss) before reclassifications		(10,867	)		(27,539	)		(38,406	)
Amounts reclassified from accumulated other comprehensive income		3,698			–			3,698
Net other comprehensive income (loss)		(7,169	)		(27,539	)		(34,708	)
Balance at September 30, 2013	$	(9,855	)	$	222,412		$	212,557
Balance at December 31, 2012	$	(32,539	)	$	326,449		$	293,910
Activity for the nine months ended September 30, 2013:
Other comprehensive income (loss) before reclassifications		9,136			(104,037	)		(94,901	)
Amounts reclassified from accumulated other comprehensive income		13,548			–			13,548
Net other comprehensive income (loss)		22,684			(104,037	)		(81,353	)
Balance at September 30, 2013	$	(9,855	)	$	222,412		$	212,557