NOTE 6 — REPURCHASE ARRANGEMENTS AND SIMILAR BORROWINGS, INCLUDING RELATED HEDGING ACTIVITY

Capstead generally pledges its Residential mortgage investments as collateral under repurchase arrangements with commercial banks and other financial institutions, referred to as counterparties, the terms and conditions of which are negotiated on a transaction-by-transaction basis when each borrowing is initiated or renewed. Repurchase arrangements entered into by the Company involve the sale and a simultaneous agreement to repurchase the transferred assets at a future date, typically with terms of 30 to 90 days, and are accounted for as financings. The Company maintains the beneficial interest in the specific securities pledged during the term of the repurchase arrangement and receives the related principal and interest payments. The amount borrowed is generally equal to the fair value of the assets pledged, as determined by the lending counterparty, less an agreed-upon discount, referred to as a “haircut.” Interest rates on these borrowings are fixed based on prevailing rates corresponding to the terms of the borrowings, and interest is paid at the termination of the repurchase arrangement at which time the Company may enter into a new repurchase arrangement at prevailing market rates with the same counterparty or repay that counterparty and negotiate financing with a different counterparty. None of the Company’s counterparties are obligated to renew or otherwise enter into new repurchase transactions at the conclusion of existing repurchase transactions. In response to declines in fair value of pledged securities due to changes in market conditions or the publishing of monthly security pay down factors, lenders typically require the Company to post additional securities as collateral, pay down borrowings or establish cash margin accounts with the counterparties in order to re-establish the agreed-upon collateral requirements, referred to as margin calls. The maturity of structured financings is directly affected by prepayments on the related mortgage pass-through securities pledged as collateral and these financings are subject to redemption by the residual bondholders.

In connection with the 2011 bankruptcy of a lending counterparty, the Company received cash in lieu of the return of $8.3 million of its pledged collateral resulting in a loss of $62,000 on the effective sale of these bonds, which is included in Miscellaneous other revenue (expense) on the Statement of Income and Gain on asset sales on the Statement of Cash Flows. The basis in the bonds effectively sold is included in Proceeds from asset sales on the Statement of Cash Flows.

Repurchase arrangements and similar borrowings (and related pledged collateral, including accrued interest receivable), classified by collateral type and remaining maturities, and related weighted average borrowing rates as of the indicated date were as follows (dollars in thousands):


*Collateral Type*	*Collateral* *Carrying* *Amount*		*Accrued* *Interest* *Receivable*		*Borrowings* *Outstanding*		*Average* *Borrowing* *Rates*
*As of December 31, 2012:*
Borrowings with maturities of 30 days or less:
Agency Securities	$	13,406,253	$	32,807	$	12,739,872		0.47	%
Borrowings with maturities greater than 30 days:
Agency Securities (31 to 90 days)		44,060		51		41,520		0.57
Similar borrowings:
Collateral for structured financings		2,846		—		2,846		8.12

	$	13,453,159	$	32,858	$	12,784,238		0.47

Year-end borrowing rates adjusted for effects of related Derivatives held as cash flow hedges								0.65
*As of December 31, 2011:*
Borrowings with maturities of 30 days or less:
Agency Securities	$	11,306,478	$	25,630	$	10,754,835		0.37	%
Borrowings with maturities greater than 30 days:
Agency Securities (31 to 90 days)		619,710		1,551		594,283		0.32
Similar borrowings:
Collateral for structured financings		3,326		—		3,326		8.04

	$	11,929,514	$	27,181	$	11,352,444		0.37

Year-end borrowing rates adjusted for effects of related Derivatives held as cash flow hedges								0.58

Average borrowings outstanding were lower than respective year-end balances primarily due to portfolio growth and differences in the timing of portfolio acquisitions relative to portfolio runoff as illustrated below (dollars in thousands):


	*Year Ended*
	*December 31, 2012*					*December 31, 2011*
	*Average* *Borrowings*		*Average* *Rate*			*Average* *Borrowings*		*Average* *Rate*
Average borrowings and rates for the indicated years, adjusted for the effects of related

Derivatives held as cash flow hedges	$	12,442,706		0.56	%	$	10,059,807		0.56	%

To help mitigate exposure to higher short-term 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 repurchase arrangements. This hedge relationship establishes a relatively stable fixed rate on related borrowings because the variable-rate payments received on the swap agreements largely offset 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 including the effects of measured hedge ineffectiveness and changes in spreads between variable rates on the swap agreements and actual borrowing rates.

During 2012 Capstead entered into $3.1 billion notional amount of new swap agreements requiring fixed rate interest payments averaging 0.49% for two-year periods beginning on various dates between July 2012 and December 2013. Swap agreements with notional amounts totaling $1.0 billion requiring fixed rate interest payments averaging 1.04% expired during the year. At December 31, 2012, the Company was a party to swap agreements hedging short-term interest rates with the following characteristics (dollars in thousands):


*Period of* *Contract Expiration*	*Notional* *Amount*		Average Fixed Rate Payment Requirement
Currently-paying two-year contracts:
First quarter 2013	$	1,100,000		0.81	%
Second quarter 2013		700,000		0.96
Third quarter 2013		300,000		0.87
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

(average expiration: 9 months)		4,200,000		0.75

Forward-starting two-year contracts:
First quarter 2015		1,100,000		0.50
Second quarter 2015		200,000		0.43
Third quarter 2015		400,000		0.47
Fourth quarter 2015		700,000		0.43

(average expiration: 29 months)		2,400,000		0.47

(average expiration: 16 months)	$	6,600,000

In addition to swap agreements hedging short-term interest rates, 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 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 7).

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. Included in the Accumulated other comprehensive income component of Stockholders’ equity are net unrealized losses on Derivatives held as cash flow hedges of $32.5 million and $30.2 million as of December 31, 2012 and December 31, 2011, respectively.

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*			*December 31,*			*December 31,*
	*Location*			*2012*			*2011*
*Balance sheet-related*
Interest rate swap agreements in a gain position (an asset) related to:
Repurchase arrangements and similar borrowings		(a	)	$	169		$	617
Interest rate swap agreements in a loss position (a liability) related to:
Repurchase arrangements and similar borrowings		(a	)		(18,671	)		(15,691	)
Unsecured borrowings		(a	)		(14,197	)		(15,657	)
Related net interest payable		(b	)		(7,788	)		(10,023	)

				$	(40,487	)	$	(40,754	)

(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 that will 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 $15.3 million at December 31, 2012.

(b)

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

Interest paid on Repurchase arrangements and similar borrowings, including related swap agreement cash flows, totaled $69.5 million, $55.2 million and $56.3 million during 2012, 2011 and 2010, respectively.


	*Location of* Gain or (Loss) Recognized in *Net Income*			*December 31*
				*2012*			*2011*			*2010*
*Income statement-related*
Components of effect on interest expense:
Amount of loss reclassified from AOCI related to the effective portion of active positions				$	(19,882	)	$	(28,066	)	$	(27,554	)
Effective portion of terminated positions					—			—			8

					(19,882	)		(28,066	)		(27,546	)
Amount of loss recognized (ineffective portion)					(542	)		(827	)		(140	)

Increase in interest expense and decrease in Net income as a result of the use of Derivatives		(a	)	$	(20,424	)	$	(28,893	)	$	(27,686	)

*Other comprehensive income-related*
Amount of loss recognized in other comprehensive income (effective portion)				$	(22,262	)	$	(51,751	)	$	(27,587	)

(a)

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