Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities

v2.3.0.15
Derivative Instruments and Hedging Activities
 9 Months Ended
Sep. 30, 2011
Derivative Instruments and Hedging Activities [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 derivatives 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 and caps. In executing on the Company's current risk management strategy, the Company has entered into interest rate swap and swaption agreements, TBA positions, and credit default swaps. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally U.S. Treasuries and 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. While the Company uses non-derivative and 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.
Interest Rate Sensitive Assets/Liabilities
Available-for-sale Securities  - The Company's RMBS investment securities 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. To mitigate the impact of this risk, the Company maintains a portfolio of financial instruments, primarily fixed-rate interest-only securities, which increase in value when interest rates increase. In addition, the Company has initiated TBA positions to further mitigate its exposure to increased prepayment speeds. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and changes in prepayment speeds.
As of September 30, 2011 and December 31, 2010, the Company had outstanding fair value of $53.2 million and $18.4 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 condensed consolidated balance sheets. In addition, the Company holds TBA positions with $375.0 million in long notional and $2.0 billion in short notional as of September 30, 2011. The Company discloses these on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. As of September 30, 2011, these contracts held a fair market value of $9.6 million, included in derivative assets, at fair value, and $2.0 million, included in derivative liabilities, at fair value, in the condensed consolidated balance sheet as of September 30, 2011. The Company did not hold any long or short notional TBA positions as of December 31, 2010.
Repurchase Agreements  - The Company monitors its repurchase agreements, which are generally floating rate debt, in relationship 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 investment securities and debt portfolios, specifically repurchase agreements with maturities of less than 6 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 from floating to fixed.
As of September 30, 2011 and December 31, 2010, the Company had the following outstanding interest rate swaps that were utilized as economic hedges of interest rate risk associated with the Company's short-term repurchase agreements:

(notional in thousands)
 
 
 
 
 
 
September 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
25,000

 
0.868
%
 
0.295
%
 
1.23

2013
 
1,275,000

 
0.795
%
 
0.292
%
 
1.63

2014
 
1,275,000

 
0.670
%
 
0.355
%
 
2.97

2015
 
820,000

 
1.575
%
 
0.299
%
 
3.77

2016
 
240,000

 
2.156
%
 
0.276
%
 
4.57

Total
 
3,635,000

 
1.017
%
 
0.315
%
 
2.77

(notional in thousands)
 
 
 
 
 
 
December 31, 2010
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2011
 
100,000

 
1.168
%
 
0.343
%
 
0.96

2012
 
25,000

 
0.868
%
 
0.308
%
 
1.98

2013
 
175,000

 
1.376
%
 
0.306
%
 
2.61

2014
 
175,000

 
1.671
%
 
0.303
%
 
3.96

2015
 
175,000

 
1.830
%
 
0.287
%
 
4.84

Total
 
650,000

 
1.526
%
 
0.306
%
 
3.29


The Company has also entered into interest rate swaps in combination with U.S. Treasuries and other RMBS to economically hedge funding cost and macro-financing risk. As of September 30, 2011 and December 31, 2010, the Company held $1.5 billion and $199.5 million, respectively, in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps:

(notional in thousands)
 
 
 
 
 
 
September 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2013
 
1,750,000

 
0.659
%
 
0.28433
%
 
1.75
Total
 
1,750,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2010
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2012
 
200,000

 
0.557
%
 
0.278
%
 
1.80
Total
 
200,000

 
 
 
 
 
 

All of the Company's interest rate swap contracts receive interest at a 1-month or 3-month LIBOR rate, except the following interest rate swap entered in combination with TBA contracts to economically hedge mortgage basis widening where the Company pays interest at a 3-month LIBOR rate:

(notional in thousands)
 
 
 
 
 
 
September 30, 2011
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2016
 
325,000

 
0.264
%
 
1.772
%
 
4.83
Total
 
325,000

 
 
 
 
 
 

The Company did not hold any interest rate swaps in combination with TBA contracts as of December 31, 2010.
Additionally, as of September 30, 2011 and December 31, 2010, the Company had the following outstanding interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would pay a fixed rate) that were utilized as macro-economic hedges:
September 30, 2011
(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)
Payer
< 6 Months
 
$
10,511

 
$
97

 
5.30
 
575,000

 
3.18
%
 
3M Libor
 
4.65

Payer
≥ 6 Months
 
14,646

 
2,749

 
11.65
 
1,875,000

 
3.09
%
 
3M Libor
 
4.04

Total Payer
 
 
$
25,157

 
$
2,846

 
11.60

 
2,450,000

 
3.11
%
 
3M Libor
 
4.18

December 31, 2010
(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)
Payer
≥ 6 Months
 
$
3,348

 
$
4,028

 
11.25
 
100,000

 
3.52
%
 
3M Libor
 
8.50


The Company has not applied hedge accounting to its current derivative portfolio held to mitigate the interest rate risk associated with its debt 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.
Foreign Currency Risk
In compliance with the Company's REIT requirements, the Company does not have exposure to foreign denominated assets or liabilities. As such, the Company is not subject to foreign currency risk.
Credit Risk
The Company has limited exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities because these securities are issued by the U.S. Department of the Treasury or government sponsored entities, or GSEs. The payment of principal and interest on the FHLMC and FNMA mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.
For non-Agency investment securities, the Company currently enters into credit default swaps to specifically 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 "Non-Risk Management Activities" section). The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency RMBS.
As of September 30, 2011, the Company held credit default swaps where the Company receives 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 where the Company is receiving protection held as of September 30, 2011:

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
September 30, 2011
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Receive
 
9/20/2013
 
460.00

 
(45,000
)
 
$
2,802

 
$
(3,126
)
 
$
(324
)
 
 
12/20/2013
 
370.00

 
(5,000
)
 
$
346

 
$
(294
)
 
$
52

 
 
6/20/2016
 
264.23

 
(250,000
)
 
$
12,649

 
$
(480
)
 
$
12,169

 
 
5/25/2046
 
356.00

 
(95,954
)
 
$
54,413

 
$
(42,930
)
 
$
11,483

 
 
Total
 
310.06

 
(395,954
)
 
$
70,210

 
$
(46,830
)
 
$
23,380


The Company did not hold any credit default swaps where the Company receives credit protection as of December 31, 2010.
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 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 September 30, 2011, the fair value of derivative financial instruments as an asset and liability position was $245.3 million and $46.2 million, respectively.
The Company mitigates the credit risk exposure on derivative financial instruments by limiting the counterparties to those major banks and financial institutions that meet established credit guidelines, and the Company seeks to transact with several different counterparties in order to reduce the 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 upon occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties. The agreements require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. As of September 30, 2011, the Company has received cash deposits from counterparties of $34.0 million and placed cash deposits of $89.2 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 condensed consolidated balance sheet.
In accordance with ASC 815, as amended and interpreted, the Company records derivative financial instruments on its condensed consolidated balance sheet 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.
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 inverse interest-only residential mortgage securities and credit default swaps.
Inverse interest-only securities with a carrying value of $162.7 million, including accrued interest receivable of $2.2 million, are accounted for as derivative financial instruments in the condensed consolidated financial statements. The following table presents the amortized cost and carrying value (which approximates fair value) of inverse interest-only securities as of September 30, 2011 and December 31, 2010:

(in thousands)
September 30, 2011
 
December 31, 2010
Face Value
$
1,167,563

 
$
219,459

Unamortized premium
—

 
—

Unamortized discount
 
 

Designated credit reserve
—

 
—

Net, unamortized
(1,005,236
)
 
(190,162
)
Amortized Cost
162,327

 
29,297

Gross unrealized gains
5,888

 
1,902

Gross unrealized losses
(7,742
)
 
(665
)
Carrying Value
$
160,473

 
$
30,534


As of September 30, 2011 and December 31, 2010, the Company also held credit default swaps where the Company provides 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 tables present credit default swaps where the Company is providing protection held as of September 30, 2011 and December 31, 2010:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
September 30, 2011
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
 
7/25/2036
 
359.94

 
117,043

 
$
7,372

 
$
(12,232
)
 
$
(4,860
)
 
 
5/25/2046
 
146.18

 
57,355

 
$
(17,836
)
 
$
13,574

 
$
(4,262
)
 
 
Total
 
289.64

 
174,398

 
$
(10,464
)
 
$
1,342

 
$
(9,122
)

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
 
 
December 31, 2010
Protection
 
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Provide
 
7/25/2036
 
378.47

 
41,576

 
$
3,137

 
$
(3,554
)
 
$
(417
)

Balance Sheet Presentation
The following table represents the gross fair value and notional amounts of the Company's derivative financial instruments treated as trading instruments as of September 30, 2011 and December 31, 2010.

(in thousands)
 
September 30, 2011
 
December 31, 2010
 
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
Notional
 
Fair Value
Notional
 
Fair Value
Notional
 
Fair Value
Notional
Inverse interest-only securities
 
$
162,703

1,167,563

 
$
—

—

 
$
30,944

219,459

 
$
—

—

Interest rate swap agreements
 
—

—

 
(33,726
)
5,060,000

 
—

—

 
(158
)
850,000

Credit default swap agreements
 
70,210

395,954

 
(10,464
)
174,398

 
3,137

41,576

 
—

—

Swaptions
 
2,846

2,450,000

 
—

—

 
4,028

100,000

 
—

—

TBAs
 
9,555

875,000

 
(1,992
)
750,000

 
—

—

 
—

—

Total
 
$
245,314

4,888,517

 
$
(46,182
)
5,984,398

 
$
38,109

361,035

 
$
(158
)
850,000


The following table provides the average monthly outstanding notional amounts of the Company's derivative financial instruments treated as trading instruments for the three and nine months ended September 30, 2011:

(in thousands)
 
Three Months Ended September 30, 2011
 
Nine Months Ended September 30, 2011
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
1,135,141

 
—

 
771,476

 
—

Interest rate swap agreements
 
—

 
4,267,609

 
—

 
2,809,212

Credit default swaps
 
385,824

 
177,461

 
138,119

 
117,610

Swaptions
 
2,129,348

 
—

 
1,117,563

 
—

TBAs
 
545,109

 
1,230,435

 
85,834

 
132,621


Income Statement Presentation
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statement of income on its derivative instruments.

(in thousands)
 
 
 
 
 
 
 
 
 
 
Trading Instruments
 
Location of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
Amount of Gain/(Loss) Recognized in Income on Derivatives
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
 
 
2011
 
2010
 
2011
 
2010
Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Interest Rate Contracts
 
 
 
 
 
 
 
 
 
 
Investment securities - RMBS
 
Gain on other derivative instruments
 
$
5,729

 
$
1,214

 
$
5,091

 
$
1,631

Investment securities - U.S. Treasuries and TBA contracts
 
Loss on interest rate swap and swaption agreements
 
6,544

 
(1,251
)
 
2,733

 
(2,299
)
Repurchase agreements
 
Loss on interest rate swap and swaption agreements
 
(45,855
)
 
(3,184
)
 
(90,913
)
 
(7,738
)
Credit default swaps - Receive protection
 
Gain on other derivative instruments
 
21,994

 
—

 
22,267

 
—

Non-Risk Management Instruments
 
 
 
 
 
 
 
 
 
 
Credit default swaps - Provide protection
 
Gain on other derivative instruments
 
(4,414
)
 
—

 
(5,589
)
 
—

Inverse interest-only securities
 
Gain on other derivative instruments
 
(948
)
 
1,884

 
15,705

 
2,566

Total
 
 
 
$
(16,950
)
 
$
(1,337
)
 
$
(50,706
)
 
$
(5,840
)
For the three and nine months ended September 30, 2011, the Company terminated 24 and 29 notional interest rate swap and swaption positions of $1.9 billion and $2.5 billion, respectively. Upon settlement of the early terminations, the Company paid $4.2 million and $5.1 million in full settlement of its net interest spread liability and recorded $17.8 million and $18.1 million in realized losses on the swaps and swaptions, respectively, including an early termination penalty.