DERIVATIVES

Please see Note 1 for additional information related to the Company’s accounting policies for derivative instruments.

As of September 30, 2011 and December 31, 2010, the Company’s derivative financial instruments are comprised entirely of interest rate swaps, and are designated as either hedging instruments or trading instruments. With respect to hedging instruments, the Company’s objective for using interest rate swaps is to minimize its exposure to the risk of increased interest expense resulting from its existing and forecasted short-term, fixed-rate borrowings. The Company continuously borrows funds via sequential fixed-rate, short-term repurchase agreement borrowings. As each fixed-rate repurchase agreement matures, it is replaced with new fixed-rate agreements based on the market interest rate in effect at the time of such replacement. This sequential rollover borrowing program creates a variable interest expense pattern. The changes in the cash flows of the interest rate swaps are expected to be highly effective at offsetting changes in the interest portion of the cash flows expected to be paid at maturity of each borrowing.

With respect to trading instruments, the Company’s objective for using interest rate swaps is to offset the changes in market value of its investments also designated as trading. See Note 3 for information related to the investments designated as trading.

The tables below summarize information about the Company’s derivative financial instruments on the balance sheet as of the dates indicated:



As of September 30, 2011
Accounting Designation	Balance Sheet Location	Fair Value		Cumulative Notional Amount		Weighted-average Fixed Rate Swapped
Hedging instruments	Derivative assets	$	—	$	—	—	%

Hedging instruments	Derivative liabilities	$	26,544	$	995,000	1.55	%
Trading instruments	Derivative liabilities	2,294		27,000		2.88	%
		$	28,838



As of December 31, 2010
Accounting Designation	Balance Sheet Location	Fair Value			Cumulative Notional Amount		Weighted-average Fixed Rate Swapped
Hedging instruments	Derivative assets	$	692		$	100,000	1.89	%
Hedging instruments	Derivative liabilities	$	(3,532	)	$	245,000	1.58	%

As of September 30, 2011, the Company had margin requirements with its swap counterparties for these interest rate swaps for which Agency MBS with a fair value of $30,691 have been posted as collateral. The following table summarizes the contractual maturities remaining for the Company’s outstanding interest rate swap agreements as of September 30, 2011:



Remaining Maturity	Notional Amount: Trading		Notional Amount: Hedging		Notional Amount: Total		Number of Swaps	Weighted-Average Fixed Rate Swapped
0-12 months	$	—	$	100,000	$	100,000	2	1.02	%
13-36 months	—		510,000		510,000		9	1.26	%
37-60 months	5,000		320,000		325,000		10	2.07	%
Over 60 months	22,000		65,000		87,000		5	2.28	%
	$	27,000	$	995,000	$	1,022,000	26	1.58	%

The table below presents the effect of the derivatives designated as trading instruments on the Company’s consolidated statements of income for the periods indicated.



		Amount of Loss Recognized in Net Income For the Three Months Ended				Amount of Loss Recognized in Net Income For the Nine Months Ended
Type of Derivative Designated as Trading	Location of Amount Recognized in Net Income	September 30, 2011		September 30, 2010		September 30, 2011		September 30, 2010
Interest rate swaps	Fair value adjustments, net	$	1,075	$	—	$	2,294	$	—

The table below presents the effect of the derivatives designated as hedging instruments on the Company’s consolidated statement of comprehensive income for the periods indicated:



Type of Derivative Designated as Cash Flow Hedge	Amount of (Gain) Loss Recognized in OCI (Effective Portion)	Location of Amount Reclassified from OCI into Net Income (Effective Portion)	Amount Reclassified from OCI into Net Income (Effective Portion)	Location of (Gain) Loss Recognized in Net Income (Ineffective Portion)	Amount of (Gain) Loss Recognized in Net Income Ineffective Portion)
For the three months ended September 30, 2011:
Interest rate swaps	$18,251	Interest expense	$3,383	Other income, net	$31

For the three months ended September 30, 2010:
Interest rate swaps	$2,699	Interest expense	$651	Other income, net	$6

For the nine months ended September 30, 2011:
Interest rate swaps	$31,974	Interest expense	$8,325	Other income, net	$55

For the nine months ended September 30, 2010:
Interest rate swaps	$7,587	Interest expense	$1,706	Other income, net	$15

The table below presents a rollforward of the activity in the Company’s AOCI related to its derivatives designated as hedging instruments for the periods presented:



	2011			2010
Balance as of January 1,	$	(2,820	)	$	1,008
Change in fair value of interest rate swaps	(31,974		)	(7,587		)
Reclassification adjustment for amounts included in statement of income	8,325			1,706
Balance as of September 30,	$	(26,469	)	$	(4,873	)

The Company estimates that an additional $10,554 related to its derivatives designated as hedging instruments will be recognized as an increase to interest expense during the next 12 months.

The interest rate swap agreements the Company has with its derivative counterparties contain various covenants related to the Company’s credit risk. Specifically, if the Company defaults on any of its indebtedness, including those circumstances whereby repayment of the indebtedness has not been accelerated by the lender, or is declared in default of any of its covenants with any counterparty, then the Company could also be declared in default of its derivative obligations. The covenant violation by the Company as of September 30, 2011, which is discussed in Note 8, did not effect any of its derivative obligations. Additionally, the agreements outstanding with our derivative counterparties allow those counterparties to require settlement of its outstanding derivative transactions if the Company fails to earn GAAP net income greater than one dollar as measured on a rolling two quarter basis. These interest rate agreements also contain provisions whereby, if the Company fails to maintain a minimum net amount of shareholders’ equity, then the Company may be declared in default on its derivative obligations. As of September 30, 2011, the Company had derivatives in a net liability position with its derivative counterparties totaling $29,325, inclusive of accrued interest but excluding any adjustment for nonperformance risk, for which it had pledged Agency MBS with a fair value of $30,691 as collateral. If the Company had breached any of these agreements as of September 30, 2011, it could have been required to settle those derivatives at their estimated termination value of $29,325.