NOTE 7 — USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING

DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

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 the first quarter of 2013 Capstead entered into $800 million notional amount of new forward-starting swap agreements requiring fixed rate interest payments averaging 0.48% for two-year periods beginning on various dates in December 2013 and January 2014. Swap agreements with notional amounts totaling $1.10 billion requiring fixed rate interest payments averaging 0.81% expired during the quarter, and were replaced with previously acquired swap agreements with notional amounts totaling $1.10 billion requiring fixed rate interest payments averaging 0.50% for two-year periods. At March 31, 2013, 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 contracts:
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
First quarter 2015		1,100,000		0.50

(average expiration: 12 months)		4,200,000		0.67

Forward-starting contracts:
Second quarter 2015		200,000		0.43
Third quarter 2015		400,000		0.47
Fourth quarter 2015		1,200,000		0.45
First quarter 2016		300,000		0.47

(average expiration: 31 months)		2,100,000		0.45

(average expiration: 18 months)	$	6,300,000

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 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*			*March 31,*			*December 31,*
	*Location*			*2013*			*2012*
*Balance sheet-related*
Interest rate swap agreements in a gain position (an asset) related to:
Repurchase arrangements and similar borrowings		(a	)	$	114		$	169
Interest rate swap agreements in a loss position (a liability) related to:
Repurchase arrangements and similar borrowings		(a	)		(13,821	)		(18,671	)
Unsecured borrowings		(a	)		(10,942	)		(14,197	)
Related net interest payable		(b	)		(8,490	)		(7,788	)

				$	(33,139	)	$	(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 March 31, 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 $11.9 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 March 31
	*Net Income*			*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				$	(5,434	)	$	(4,965	)
Amount of gain recognized (ineffective portion)					120			141

Increase in interest expense and decrease in Net income as a result of the use of Derivatives		(a	)	$	(5,314	)	$	(4,824	)

*Other comprehensive income-related:*
Amount of loss recognized in Other comprehensive income (effective portion)				$	2,479		$	(1,751	)

(a)

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

The Company’s swap agreements and 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 Repurchase arrangements and similar borrowings. Offsetting disclosures for all Derivatives held as well as repurchase arrangements and similar borrowings outstanding were as follows (in thousands):


	*Offsetting of Derivative Assets*
	Gross Amounts of Recognized Assets		Gross Amounts Offset in the Balance Sheet		Net Amounts of Assets Presented in the Balance Sheet		Gross Amounts Not Offset in the Balance Sheet
	Gross Amounts of Recognized Assets		Gross Amounts Offset in the Balance Sheet		Net Amounts of Assets Presented in the Balance Sheet		Financial Instruments			Cash Collateral Received		Net Amount
*As of March 31, 2013:*
Counterparty 1	$	95	$	—	$	95	$	(95	)	$	—	$	—
Counterparty 2		19		—		19		(19	)		—		—

	$	114	$	—	$	114	$	(114	)	$	—	$	—

*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* Amounts of Recognized Liabilities ^(a)		Gross Amounts Offset in the Balance Sheet		Net Amounts of Liabilities Presented in the Balance Sheet ^(a)		Gross Amounts Not Offset in the Balance Sheet
	*Gross* Amounts of Recognized Liabilities ^(a)		Gross Amounts Offset in the Balance Sheet				Financial Instruments			Cash Collateral Pledged ^(b)			Net Amount
*As of March 31, 2013:*
Derivatives by counterparty:
Counterparty 1	$	21,407	$	—	$	21,407	$	(95	)	$	(21,312	)	$	—
Counterparty 2		10,359		—		10,359		(19	)		(9,600	)		740
Counterparty 3		1,487		—		1,487		—			(1,487	)		—

		33,253		—		33,253		(114	)		(32,399	)		740
Repurchase arrangements and similar borrowings		12,824,944		—		12,824,944		(12,824,944	)		—			—

	$	12,858,197	$	—	$	12,858,197	$	(12,825,058	)	$	(32,399	)	$	740

*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 $8.5 million and $7.8 million on interest rate swap agreements and $3.4 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 March 31, 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 period ended March 31, 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 December 31, 2012	$	(32,539	)	$	326,449		$	293,910

Other comprehensive income before reclassifications		2,479			(7,705	)		(5,226	)
Amounts reclassified from accumulated other comprehensive income		5,434			—			5,434

Net current-period other comprehensive income		7,913			(7,705	)		208

Balance at March 31, 2013	$	(24,626	)	$	318,744		$	294,118