Annual report pursuant to Section 13 and 15(d)

Derivative Instruments and Hedging Activities (Notes)

v3.6.0.2
Derivative Instruments and Hedging Activities (Notes)
 12 Months Ended
Dec. 31, 2016
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivative Instruments and Hedging Activities
Derivative Instruments and Hedging Activities
The Company enters into a variety of derivative and non-derivative instruments in connection with its risk management activities. The Company’s primary objective for executing these derivative 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, caps, credit default swaps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBAs, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, credit default swaps and total return swaps (based on the Markit IOS Index). The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally Agency interest-only securities.
The following summarizes the Company’s significant asset and liability classes, the risk exposure for these classes, and the Company’s risk management activities used to mitigate certain of these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. Any of the Company’s derivative and non-derivative instruments may be entered into in conjunction with one another in order to mitigate risks associated with the Company’s investment portfolio. As a result, the following discussions of each type of instrument should be read as a collective representation of the Company’s risk mitigation efforts and should not be considered independent of one another. While the Company uses derivative and non-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
In accordance with ASC 815, Derivatives and Hedging, or ASC 815, the Company records derivative financial instruments on its consolidated balance sheets as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they qualify for hedge accounting treatment. Due to the volatility of the credit markets and difficulty in effectively matching pricing or cash flows, the Company has elected to treat all current derivative contracts as trading instruments.
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of December 31, 2016 and December 31, 2015.
(in thousands)
 
December 31, 2016
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
127,843

 
$
740,844

 
$
—

 
$
—

Interest rate swap agreements
 
109,531

 
18,471,063

 
(495
)
 
1,900,000

Credit default swaps
 
—

 
—

 
—

 
—

Swaptions, net
 
39,881

 
825,000

 
(1,645
)
 
600,000

TBAs
 
4,294

 
536,000

 
(10,344
)
 
953,000

Put and call options for TBAs, net
 
42,633

 
1,136,000

 
—

 
—

Markit IOS total return swaps
 
—

 
—

 
(17
)
 
90,593

Forward purchase commitments
 
—

 
—

 
—

 
—

Total
 
$
324,182

 
$
21,708,907

 
$
(12,501
)
 
$
3,543,593


(in thousands)
 
December 31, 2015
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
159,582

 
$
932,037

 
$
—

 
$
—

Interest rate swap agreements
 
91,757

 
14,268,806

 
—

 
—

Credit default swaps
 
—

 
—

 
(703
)
 
125,000

Swaptions, net
 
17,374

 
4,700,000

 
(4,831
)
 
500,000

TBAs
 
1,074

 
847,000

 
(1,324
)
 
550,000

Markit IOS total return swaps
 
1,645

 
889,418

 
—

 
—

Forward purchase commitments
 
77

 
98,736

 
(427
)
 
187,384

Total
 
$
271,509

 
$
21,735,997

 
$
(7,285
)
 
$
1,362,384



Comprehensive Income (Loss) Statement Presentation
The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk and credit risk associated with its 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 and its other derivative instruments.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the consolidated statements of comprehensive income (loss):
Trading Instruments
 
Location of Gain (Loss) Recognized in Income on Derivatives
 
Amount of Gain (Loss) Recognized in Income on Derivatives
(in thousands)
 
 
 
Year Ended
December 31,
 
 
 
 
2016
 
2015
 
2014
Interest rate risk management
 
 
 
 
 
 
 
 
TBAs (1)
 
Gain (loss) on other derivative instruments
 
$
51,816

 
$
(39,748
)
 
$
(69,921
)
Short U.S. Treasuries (1)
 
Gain (loss) on other derivative instruments
 
—

 
125

 
(8
)
Put and call options for TBAs (1)
 
Gain (loss) on other derivative instruments
 
64,920

 
6,846

 
(14,070
)
Put and call options for U.S. Treasuries (1)
 
Gain (loss) on other derivative instruments
 
—

 
(837
)
 
—

Constant maturity swaps (1)
 
Gain (loss) on other derivative instruments
 
—

 
6,164

 
6,340

Interest rate swap agreements - Receivers (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
37,272

 
52,785

 
201,536

Interest rate swap agreements - Payers (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
(19,986
)
 
(69,495
)
 
(114,121
)
Swaptions (1)
 
Gain (loss) on interest rate swap and swaption agreements
 
11,209

 
(63,797
)
 
(242,795
)
Markit IOS total return swaps (1)
 
Gain (loss) on other derivative instruments
 
(36,898
)
 
(13,371
)
 
8,061

Interest rate swap agreements - Payers (2)
 
Gain (loss) on interest rate swap and swaption agreements
 
16,876

 
(130,114
)
 
(190,267
)
Credit risk management
 
 
 
 
 
 
 
 
Credit default swaps - Receive protection (3)
 
Gain (loss) on other derivative instruments
 
962

 
(294
)
 
1,742

Non-risk management
 
 
 
 
 
 
 
 
TBAs
 
Gain (loss) on other derivative instruments
 
—

 
—

 
(4,701
)
Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
18,579

 
36,066

 
55,028

Forward purchase commitments
 
Gain on residential mortgage loans held-for-sale
 
2,418

 
(1,668
)
 
4,729

Total
 
 
 
$
147,168

 
$
(217,338
)
 
$
(358,447
)

____________________
(1)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s investment portfolio.
(2)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s repurchase agreements and FHLB advances.
(3)
Includes derivative instruments held to mitigate credit risk associated with the Company’s non-Agency RMBS and residential mortgage loans held-for-sale.

For the years ended December 31, 2016, 2015 and 2014, the Company recognized $21.1 million, $85.6 million and $91.8 million, respectively, of expenses for the accrual and/or settlement of the net interest expense associated with its interest rate swaps. The expenses result from paying either a fixed interest rate or LIBOR interest on an average $15.5 billion, $16.1 billion, and $23.3 billion notional, respectively, and receiving either LIBOR interest or a fixed interest rate.
The following tables present information with respect to the volume of activity in the Company’s derivative instruments during the years ended December 31, 2016 and 2015:
 
Year Ended December 31, 2016
(in thousands)
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
Inverse interest-only securities
$
932,037

 
$
—

 
$
(191,193
)
 
$
740,844

 
$
836,707

 
$
—

Interest rate swap agreements
14,268,806

 
25,103,456

 
(19,001,199
)
 
20,371,063

 
15,506,763

 
16,032

Credit default swaps
125,000

 
10,000

 
(135,000
)
 
—

 
71,257

 
1,022

Swaptions, net
5,200,000

 
1,668,000

 
(6,643,000
)
 
225,000

 
2,449,268

 
(98,016
)
TBAs, net
297,000

 
(10,173,000
)
 
8,387,000

 
(1,489,000
)
 
(531,866
)
 
57,616

Put and call options for TBAs, net
—

 
11,260,000

 
(12,396,000
)
 
(1,136,000
)
 
2,569,117

 
22,288

Markit IOS total return swaps
889,418

 
99,911

 
(898,736
)
 
90,593

 
471,028

 
(13,374
)
Forward purchase commitments
286,120

 
1,548,027

 
(1,834,147
)
 
—

 
269,562

 
2,068

Total
$
21,998,381

 
$
29,516,394

 
$
(32,712,275
)
 
$
18,802,500

 
$
21,641,836

 
$
(12,364
)
 
Year Ended December 31, 2015
(in thousands)
Beginning of Period Notional Amount
 
Additions
 
Settlement, Termination, Expiration or Exercise
 
End of Period Notional Amount
 
Average Notional Amount
 
Realized Gain (Loss), net (1)
Inverse interest-only securities
$
1,168,226

 
$
12,563

 
$
(248,752
)
 
$
932,037

 
$
1,050,906

 
$
64

Interest rate swap agreements
18,584,000

 
26,868,227

 
(31,183,421
)
 
14,268,806

 
16,091,714

 
(126,870
)
Credit default swaps
125,000

 
—

 
—

 
125,000

 
125,000

 
—

Swaptions, net
12,410,000

 
8,550,000

 
(15,760,000
)
 
5,200,000

 
9,780,027

 
(99,273
)
TBAs, net
(1,325,000
)
 
(7,266,000
)
 
8,888,000

 
297,000

 
(773,381
)
 
(46,835
)
Short U.S. Treasuries
—

 
(50,000
)
 
50,000

 
—

 
—

 
125

Put and call options for TBAs, net
2,000,000

 
1,250,000

 
(3,250,000
)
 
—

 
(120,548
)
 
6,331

Put and call options for U.S. Treasuries, net
—

 
500,000

 
(500,000
)
 
—

 
685

 
(837
)
Constant maturity swaps
14,000,000

 
6,000,000

 
(20,000,000
)
 
—

 
2,257,534

 
7,694

Markit IOS total return swaps
598,459

 
1,626,514

 
(1,335,555
)
 
889,418

 
950,206

 
(11,296
)
Forward purchase commitments
554,838

 
3,512,843

 
(3,781,561
)
 
286,120

 
563,108

 
(21
)
Total
$
48,115,523

 
$
41,004,147

 
$
(67,121,289
)
 
$
21,998,381

 
$
29,925,251

 
$
(270,918
)
____________________
(1)
Excludes net interest paid or received in full settlement of the net interest spread liability.

Cash flow activity related to derivative instruments is reflected within the operating activities and investing activities sections of the consolidated statements of cash flows. Derivative fair value adjustments are reflected within the unrealized (gain) loss on interest rate swaps and swaptions, unrealized gain on other derivative instruments, and gain on residential mortgage loans held-for-sale line items within the operating activities section of the consolidated statements of cash flows. Realized gains and losses on interest rate swap and swaption agreements are reflected within the loss on termination and option expiration of interest rate swaps and swaptions line item within the operating activities section of the consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the (purchases) short sales of other derivative instruments, proceeds from sales (payments for termination) of other derivative instruments, net and increase (decrease) in due to counterparties, net line items within the investing activities section of the consolidated statements of cash flows.
Interest Rate Sensitive Assets/Liabilities
The Company’s RMBS investment securities and MSR are generally subject to change in value when mortgage rates decline or increase, depending on the type of investment. Rising mortgage rates generally result in a slowing of refinancing activity, which slows prepayments and results in a decline in the value of the Company’s fixed-rate Agency pools and an increase in the value of the Company’s MSR. To mitigate the impact of this risk, the Company maintains a portfolio of fixed-rate interest-only securities, which increase in value when interest rates increase, as well as TBA positions, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, interest rate swap and swaption agreements and Markit IOS total return swaps to further mitigate its exposure to higher interest rates, decreased prepayment speeds and widening mortgage spreads.
As of December 31, 2016 and December 31, 2015, the Company had outstanding fair value of $71.1 million and $42.9 million, respectively, of interest-only securities in place to economically hedge its investment securities. These interest-only securities are included in AFS securities, at fair value, in the consolidated balance sheets.
The Company is exposed to interest rate risk on residential mortgage loans from the time it commits to purchase a mortgage loan until it acquires the loan from the originator and subsequently sells the loan to a third party. Changes in interest rates impact the market price for the mortgage loans. For example, as market interest rates decline, the value of residential mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company may enter into derivative contracts to hedge the interest rate risk related to its commitments to purchase residential mortgage loans and residential mortgage loans held-for-sale, such as interest rate swaps, swaptions, TBA positions, short U.S. Treasuries, put and call options for TBAs and U.S. Treasuries and constant maturity swaps.
TBAs. At times, the Company may use TBAs for risk management purposes or as a means of deploying capital until targeted investments are available and to take advantage of temporary displacements in the marketplace. Additionally, the Company may use TBAs independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks associated with the Company’s investment portfolio. TBAs are forward contracts for the purchase (long notional positions) or sale (short notional positions) of Agency RMBS. The issuer, coupon and stated maturity of the Agency RMBS are predetermined as well as the trade price, face amount and future settle date (published each month by the Securities Industry and Financial Markets Association). However, the specific Agency RMBS to be delivered upon settlement is not known at the time of the TBA transaction. As a result, and because physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.
As of December 31, 2016, $1.5 billion of the Company’s long notional TBA positions and $3.0 billion of the Company’s short notional TBA positions were held in order to economically hedge portfolio risk. As of December 31, 2015, $847.0 million of the Company’s long notional TBA positions and $550.0 million of the Company’s short notional TBA positions were held in order to economically hedge portfolio risk. The Company discloses these positions on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. The following tables present the notional amount, cost basis, market value and carrying value (which approximates fair value) of the Company’s TBA positions as of December 31, 2016 and December 31, 2015:
 
As of December 31, 2016
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
1,500,000

 
$
1,576,270

 
$
1,576,875

 
$
605

 
$
—

Sale contracts
(2,989,000
)
 
(3,028,470
)
 
(3,035,125
)
 
3,689

 
(10,344
)
TBAs, net
$
(1,489,000
)
 
$
(1,452,200
)
 
$
(1,458,250
)
 
$
4,294

 
$
(10,344
)
 
As of December 31, 2015
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
847,000

 
$
858,572

 
$
859,646

 
$
1,074

 
$
—

Sale contracts
(550,000
)
 
(568,813
)
 
(570,137
)
 
—

 
(1,324
)
TBAs, net
$
297,000

 
$
289,759

 
$
289,509

 
$
1,074

 
$
(1,324
)
___________________
(1)
Notional amount represents the face amount of the underlying Agency RMBS.
(2)
Cost basis represents the forward price to be paid (received) for the underlying Agency RMBS.
(3)
Market value represents the current market value of the TBA (or of the underlying Agency RMBS) as of period-end.
(4)
Net carrying value represents the difference between the market value of the TBA as of period-end and its cost basis, and is reported in derivative assets / (liabilities), at fair value, in the consolidated balance sheets.

Put and Call Options for TBAs. The Company may use put and call options for TBAs independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks associated with the Company’s investment portfolio. As of December 31, 2016, the Company had purchased put options for TBAs with a notional amount of $2.5 billion and short sold call options for TBAs with a notional amount of $3.6 billion. The last of the options expires in February 2017. The put and call options had a net fair market value of $42.6 million included in derivative assets, at fair value, on the consolidated balance sheet as of December 31, 2016. The Company did not hold any put and call options for TBAs as of December 31, 2015.
Interest Rate Swap Agreements. The Company may use interest rate swaps independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks associated with the Company’s investment portfolio. As of December 31, 2016 and December 31, 2015, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk associated with the Company’s investment portfolio whereby the Company receives interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2016
Swaps Maturities
 
Notional Amounts
 
Weighted Average Fixed Pay Rate
 
Weighted Average Receive Rate
 
Weighted Average Maturity (Years)
2018
 
$
4,040,000

 
1.307
%
 
0.973
%
 
1.58

2020
 
310,000

 
1.545
%
 
0.881
%
 
3.59

2021 and Thereafter
 
900,000

 
2.378
%
 
0.997
%
 
4.24

Total
 
$
5,250,000

 
1.504
%
 
0.972
%
 
2.16

(notional in thousands)
 
 
 
 
 
 
December 31, 2015
Swaps Maturities
 
Notional Amounts
 
Weighted Average Fixed Pay Rate
 
Weighted Average Receive Rate
 
Weighted Average Maturity (Years)
2018
 
$
2,040,000

 
1.563
%
 
0.487
%
 
2.94

2020 and Thereafter
 
1,210,000

 
2.164
%
 
0.531
%
 
5.08

Total
 
$
3,250,000

 
1.787
%
 
0.503
%
 
3.74



Additionally, as of December 31, 2016 and December 31, 2015, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk associated with the Company’s investment portfolio whereby the Company pays interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
December 31, 2016
Swaps Maturities
 
Notional Amounts
 
Weighted Average Pay Rate
 
Weighted Average Fixed Receive Rate
 
Weighted Average Maturity (Years)
2018
 
$
575,000

 
0.911
%
 
1.440
%
 
1.89

2019
 
500,000

 
0.882
%
 
1.042
%
 
2.06

2020
 
510,000

 
0.881
%
 
1.580
%
 
3.59

2021 and Thereafter
 
3,479,000

 
0.963
%
 
2.137
%
 
5.52

Total
 
$
5,064,000

 
0.941
%
 
1.894
%
 
4.57

(notional in thousands)
 
 
 
 
 
 
December 31, 2015
Swaps Maturities
 
Notional Amounts
 
Weighted Average Pay Rate
 
Weighted Average Fixed Receive Rate
 
Weighted Average Maturity (Years)
2018
 
$
575,000

 
0.329
%
 
1.440
%
 
2.89

2020 and Thereafter
 
2,589,000

 
0.453
%
 
2.301
%
 
7.00

Total
 
$
3,164,000

 
0.431
%
 
2.145
%
 
6.26



The Company monitors its borrowings under repurchase agreements and FHLB advances, which are generally floating rate debt, in relation to the rate profile of its investment securities. When it is cost effective to do so, the Company may enter into interest rate swap arrangements to align the interest rate composition of its borrowings under repurchase agreements and FHLB advances with that of its investment securities and debt portfolios. This particularly applies to borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (i.e., LIBOR) of the interest rate swaps match the terms of the underlying debt, resulting in an effective conversion of the rate of the related repurchase agreement or FHLB advance from floating to fixed.
As of December 31, 2016 and December 31, 2015, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) associated with the Company’s short-term repurchase agreements and FHLB advances:
(notional in thousands)
 
 
 
 
 
 
December 31, 2016
Swaps Maturities
 
Notional Amount (1)
 
Weighted Average Fixed Pay Rate (2)
 
Weighted Average Receive Rate (2)
 
Weighted Average Maturity (Years) (2)
2017
 
$
2,375,000

 
0.765
%
 
0.934
%
 
0.59

2018
 
1,300,000

 
1.002
%
 
0.860
%
 
1.60

2019
 
350,000

 
1.283
%
 
0.895
%
 
2.44

2020
 
1,150,000

 
1.463
%
 
0.930
%
 
3.78

2021 and Thereafter
 
4,882,063

 
1.897
%
 
0.946
%
 
6.59

Total
 
$
10,057,063

 
1.405
%
 
0.927
%
 
3.85

(notional in thousands)
 
 
 
 
 
 
December 31, 2015
Swaps Maturities
 
Notional Amount (1)
 
Weighted Average Fixed Pay Rate (2)
 
Weighted Average Receive Rate (2)
 
Weighted Average Maturity (Years) (2)
2016
 
$
1,700,000

 
0.462
%
 
0.481
%
 
0.73

2017
 
2,375,000

 
0.765
%
 
0.510
%
 
1.59

2018
 
800,000

 
0.944
%
 
0.384
%
 
2.14

2019
 
350,000

 
1.283
%
 
0.340
%
 
3.44

2020 and Thereafter
 
2,629,806

 
1.821
%
 
0.371
%
 
8.04

Total
 
$
7,854,806

 
1.094
%
 
0.437
%
 
3.71


____________________
(1)
Notional amount includes $777.1 million in forward starting interest rate swaps as of December 31, 2016. The Company did not have any forward starting interest rate swaps as of December 31, 2015.
(2)
Weighted averages exclude forward starting interest rate swaps. As of December 31, 2016, the weighted average fixed pay rate on interest rate swaps starting in 2017 was 2.0%. The Company did not have any forward starting interest rate swaps as of December 31, 2015.

Interest Rate Swaptions. The Company may use interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would either pay or receive a fixed rate) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks associated with the Company’s investment portfolio. As of December 31, 2016 and December 31, 2015, the Company had the following outstanding interest rate swaptions that were utilized as macro-economic hedges:
 
 
December 31, 2016
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Purchase contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
29,360

 
$
42,149

 
1.22
 
$
4,500,000

 
2.16
%
 
3M Libor
 
4.8

Payer
 
≥ 6 Months
 
13,655

 
792

 
6.70
 
300,000

 
3.50
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
43,015

 
$
42,941

 
1.23
 
$
4,800,000

 
2.24
%
 
3M Libor
 
5.1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
(51,355
)
 
$
(1,414
)
 
5.81
 
$
(500,000
)
 
3.40
%
 
3M Libor
 
10.0

Payer
 
≥ 6 Months
 
(29,893
)
 
(938
)
 
6.77
 
(300,000
)
 
3.50
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(81,248
)
 
$
(2,352
)
 
6.05
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
—

 
$
(2,353
)
 
2.30
 
$
(3,775,000
)
 
3M Libor
 
1.19
%
 
4.9

Total Receiver
 
 
 
$
—

 
$
(2,353
)
 
2.30
 
$
(3,775,000
)
 
3M Libor
 
1.19
%
 
4.9

 
 
December 31, 2015
(notional and dollars in thousands)
 
Option
 
Underlying Swap
Swaption
 
Expiration
 
Cost
 
Fair Value
 
Average Months to Expiration
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Term (Years)
Purchase contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
375

 
$
174

 
0.75
 
$
2,000,000

 
2.23
%
 
3M Libor
 
6.3

Payer
 
≥ 6 Months
 
126,273

 
19,150

 
39.17
 
4,500,000

 
3.69
%
 
3M Libor
 
5.8

Total Payer
 
 
 
$
126,648

 
$
19,324

 
38.51
 
$
6,500,000

 
3.24
%
 
3M Libor
 
5.9

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
≥ 6 Months
 
$
(81,248
)
 
$
(6,738
)
 
18.01
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(81,248
)
 
$
(6,738
)
 
18.01
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
(100
)
 
$
(43
)
 
0.73
 
$
(500,000
)
 
3M Libor
 
1.75
%
 
10.0

Total Receiver
 
 
 
$
(100
)
 
$
(43
)
 
0.73
 
$
(500,000
)
 
3M Libor
 
1.75
%
 
10.0



Markit IOS Total Return Swaps. The Company may use total return swaps (agreements whereby the Company receives or makes payments based on the total return of an underlying instrument or index, such as the Markit IOS Index, in exchange for fixed or floating rate interest payments) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks associated with the Company’s investment portfolio. The Company enters into total return swaps to help mitigate the potential impact of larger increases or decreases in interest rates on the performance of our investment portfolio (referred to as “convexity risk”). Total return swaps based on the Markit IOS Index are intended to synthetically replicate the performance of interest-only securities. The Company had the following total return swap agreements in place at December 31, 2016 and December 31, 2015:
(notional and dollars in thousands)
 
 
 
 
 
December 31, 2016
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(45,083
)
 
$
(5
)
 
$
(320
)
 
$
(325
)
January 12, 2044
 
(45,510
)
 
(12
)
 
(366
)
 
(378
)
Total
 
$
(90,593
)
 
$
(17
)
 
$
(686
)
 
$
(703
)
(notional and dollars in thousands)
 
 
 
 
 
December 31, 2015
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(369,639
)
 
$
456

 
$
(866
)
 
$
(410
)
January 12, 2044
 
(325,003
)
 
350

 
(1,679
)
 
(1,329
)
January 12, 2045
 
(194,776
)
 
839

 
1,162

 
2,001

Total
 
$
(889,418
)
 
$
1,645

 
$
(1,383
)
 
$
262



Credit Risk
The Company’s exposure to credit losses on its Agency RMBS portfolio is limited due to implicit or explicit backing from the GSEs. The payment of principal and interest on the Freddie Mac and Fannie Mae mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
Credit Default Swaps. For non-Agency investment securities, residential mortgage loans and commercial real estate assets, the Company may enter into credit default swaps to hedge credit risk. In future periods, the Company could enhance its credit risk protection, enter into further paired derivative positions, including both long and short credit default swaps, and/or seek opportunistic trades in the event of a market disruption (see discussion under “Non-Risk Management Activities” below). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS, residential mortgage loans and commercial real estate assets.
As of December 31, 2015 and during the year ended December 31, 2016, the Company held credit default swaps through which the Company received credit protection for a fixed premium. The maximum payouts for these credit default swaps are limited to the current notional amounts of each swap contract. Maximum payouts for credit default swaps do not represent the expected future cash requirements, as the Company’s credit default swaps are typically liquidated or expire and are not exercised by the holder of the credit default swaps.
The following table presents credit default swaps held as of December 31, 2015 through which the Company received credit protection:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2015
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable) Receivable
 
Unrealized Gain (Loss)
Receive
 
June 20, 2016
 
105.50

 
$
(100,000
)
 
$
(502
)
 
$
(260
)
 
$
(762
)
 
 
December 20, 2016
 
496.00

 
(25,000
)
 
(201
)
 
(4,062
)
 
(4,263
)
 
 
Total
 
183.60

 
$
(125,000
)
 
$
(703
)
 
$
(4,322
)
 
$
(5,025
)

The Company did not hold any credit default swaps as of December 31, 2016.
Derivative financial instruments contain an element of credit risk if counterparties are unable to meet the terms of the agreements. Credit risk associated with derivative financial instruments is measured as the net replacement cost should the counterparties that owe the Company under such contracts completely fail to perform under the terms of these contracts, assuming there are no recoveries of underlying collateral, as measured by the market value of the derivative financial instruments. As of December 31, 2016, the fair value of derivative financial instruments as an asset and liability position was $324.2 million and $12.5 million, respectively.
The Company attempts to mitigate its credit risk exposure on derivative financial instruments by limiting its counterparties to banks and financial institutions that meet established credit guidelines. The Company also seeks to spread its credit risk exposure across multiple counterparties in order to reduce its exposure to any single counterparty. Additionally, the Company reduces credit risk on the majority of its derivative instruments by entering into agreements that permit the closeout and netting of transactions with the same counterparty or clearing agency, in the case of centrally cleared interest rate swaps, upon the occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties and clearing agencies, which require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of December 31, 2016, the Company had received cash deposits from counterparties of $69.4 million and placed cash deposits of $223.3 million in accounts maintained by counterparties, of which the amounts are netted on a counterparty basis and classified within restricted cash, due from counterparties, or due to counterparties on the Company’s consolidated balance sheets.
Non-Risk Management Activities
The Company has entered into certain financial instruments that are considered derivative contracts under ASC 815 that are not for purposes of hedging. These contracts are currently limited to forward purchase commitments and inverse interest-only RMBS.
Commitments to Purchase Residential Mortgage Loans Held-for-Sale. Prior to a mortgage loan purchase, the Company may enter into forward purchase commitments with counterparties whereby the Company commits to purchasing the loans at a particular interest rate, provided the borrower elects to close the loan. These commitments to purchase mortgage loans have been defined as derivatives and are, therefore, recorded on the Company’s consolidated balance sheets as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the Company’s consolidated balance sheets as adjustments to the carrying value of these assets or liabilities with a corresponding adjustment recognized in current period earnings. As of December 31, 2015, the Company had outstanding commitments to purchase $286.1 million of mortgage loans, subject to fallout if the loans did not close, with a fair value asset of $77,227 and a fair value liability of $427,468. The Company did not have any residential mortgage loan purchase commitments outstanding at December 31, 2016.
Inverse Interest-Only Securities. As of December 31, 2016 and December 31, 2015, inverse interest-only securities with a carrying value of $127.8 million and $159.6 million, including accrued interest receivable of $1.2 million and $1.7 million, respectively, are accounted for as derivative financial instruments in the consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of December 31, 2016 and December 31, 2015:
(in thousands)
December 31,
2016
 
December 31,
2015
Face Value
$
740,844

 
$
932,037

Unamortized premium
—

 
—

Unamortized discount
 
 
 
Designated credit reserve
—

 
—

Net, unamortized
(631,082
)
 
(792,178
)
Amortized Cost
109,762

 
139,859

Gross unrealized gains
18,389

 
19,655

Gross unrealized losses
(1,552
)
 
(1,608
)
Carrying Value
$
126,599

 
$
157,906