TWO Quarterly report pursuant to Section 13 or 15(d)

Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

9 Months Ended

Sep. 30, 2024

Derivative Instruments and Hedging Activities Disclosure [Abstract]

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 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, principally cash flow volatility associated with interest rate risk (including associated prepayment risk). Specifically, the Company enters into derivative and non-derivative instruments to economically hedge interest rate risk or “duration mismatch (or gap)” by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to floating-rate borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (e.g., Overnight Index Swap Rate, or OIS, or Secured Overnight Financing Rate, or SOFR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration.

To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio, its cash flows, and its loan origination pipeline, 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, total return swaps and forward mortgage loan sale commitments.In executing on the Company’s current risk management strategy, the Company has entered into TBAs, interest rate swap and swaption agreements, futures, options on futures, IRLCs and forward mortgage loan sale commitments. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally MSR and interest-only securities (see discussion below).

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 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. 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, the Company records derivative financial instruments on its condensed 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 are designated or qualify as hedge instruments. Due to the volatility of the interest rate and credit markets and difficulty in effectively matching pricing or cash flows, the Company has not designated any current derivatives as hedging instruments.

The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading derivatives as of September 30, 2024 and December 31, 2023:


	September 30, 2024
	Derivative Assets				Derivative Liabilities
(in thousands)	Fair Value		Notional		Fair Value		Notional
Inverse interest-only securities	$	11,842	$	142,011	$	—	$	—
Interest rate swap agreements	—		—		—		14,197,205


Swaptions, net	—		—		—		—
TBAs	184		(34,000)		(16,725)		5,098,000


Futures, net	—		—		—		(3,693,900)


Interest rate lock commitments	478		33,381		—		—
Forward mortgage loan sale commitments	68		26,786		(39)		9,612
Total	$	12,572	$	168,178	$	(16,764)	$	15,610,917


	December 31, 2023
	Derivative Assets				Derivative Liabilities
(in thousands)	Fair Value		Notional		Fair Value		Notional
Inverse interest-only securities	$	12,292	$	163,735	$	—	$	—
Interest rate swap agreements	—		—		—		17,788,114


Swaptions, net	19		(200,000)		—		—
TBAs	72,980		2,979,000		(21,506)		518,000


Futures, net	—		—		—		(6,203,050)


Interest rate lock commitments	—		—		—		—
Forward mortgage loan sale commitments	—		—		—		—
Total	$	85,291	$	2,942,735	$	(21,506)	$	12,103,064

Comprehensive Income (Loss) Statement Presentation

The Company has not applied hedge accounting to its current derivative portfolio held to mitigate interest rate risk and credit risk. As a result, the Company is subject to volatility in its earnings due to movement in the unrealized gains and losses associated with its derivative instruments.

The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements of comprehensive income (loss):


Derivative Instruments	Location of Gain (Loss) Recognized in Income	Amount of Gain (Loss) Recognized in Income
		Three Months Ended				Nine Months Ended
(in thousands)		September 30,				September 30,
		2024		2023		2024		2023
Interest rate risk management:
TBAs	(Loss) gain on other derivative instruments	$	84,073	$	(90,662)	$	(2,438)	$	(184,909)

Futures	(Loss) gain on other derivative instruments	(119,553)		179,697		16,061		166,533


Options on futures	(Loss) gain on other derivative instruments	—		(779)		(127)		(779)
Interest rate swaps - Payers	(Loss) gain on interest rate swap and swaption agreements	(201,417)		160,099		17,521		211,941
Interest rate swaps - Receivers	(Loss) gain on interest rate swap and swaption agreements	29,155		(47,937)		(69,292)		(125,596)
Swaptions	(Loss) gain on interest rate swap and swaption agreements	—		(253)		31		(57)
Interest rate lock commitments	Gain on mortgage loans held-for-sale	478		—		478		—
Forward mortgage loan sale commitments	Gain on mortgage loans held-for-sale	29		—		29		—




Non-risk management:

Inverse interest-only securities	(Loss) gain on other derivative instruments	2,758		(2,044)		631		(3,243)

Total		$	(204,477)	$	198,121	$	(37,106)	$	63,890

For the three and nine months ended September 30, 2024, the Company recognized income of $17.1 million and $46.4 million, respectively, for the accrual and/or settlement of the net interest spread associated with its interest rate swaps. The income results from receiving either a floating interest rate (OIS or SOFR) or a fixed interest rate and paying either a fixed interest rate or a floating interest rate (OIS or SOFR) on an average $13.4 billion and $13.3 billion notional, respectively. For the three and nine months ended September 30, 2023, the Company recognized income of $6.9 million and $13.9 million respectively, for the accrual and/or settlement of the net interest spread associated with its interest rate swaps. The income results from receiving either a floating interest rate (OIS or SOFR) or a fixed interest rate and paying either a fixed interest rate or a floating interest rate (OIS or SOFR) on an average $8.9 billion and $6.9 billion notional, respectively.

The following tables present information with respect to the volume of activity in the Company’s derivative instruments during the three and nine months ended September 30, 2024 and 2023:


	Three Months Ended September 30, 2024
(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	$	149,152	$	—	$	(7,141)	$	142,011	$	145,931	$	—
Interest rate swap agreements	11,739,471		10,354,868		(7,897,134)		14,197,205		13,365,113		(86,310)


Swaptions, net	—		—		—		—		—		—
TBAs, net	4,983,000		14,936,000		(14,855,000)		5,064,000		4,799,826		90,444



Futures, net	(6,308,900)		(3,253,400)		5,868,400		(3,693,900)		(4,975,350)		(117,162)


Interest rate lock commitments	12,879		69,927		(49,425)		33,381		26,775		—
Forward mortgage loan sale commitments	12,879		69,927		(46,408)		36,398		26,872		—
Total	$	10,588,481	$	22,177,322	$	(16,986,708)	$	15,779,095	$	13,389,167	$	(113,028)


	Three Months Ended September 30, 2023
(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	$	179,542	$	—	$	(8,035)	$	171,507	$	175,850	$	—
Interest rate swap agreements	8,977,714		1,307,773		(1,739,522)		8,545,965		8,869,676		(5,096)


Swaptions, net	(200,000)		(200,000)		200,000		(200,000)		(186,957)		(80)
TBAs, net	3,051,000		9,704,000		(10,561,000)		2,194,000		2,713,272		(88,858)



Futures, net	(6,624,550)		(7,617,280)		6,371,380		(7,870,450)		(7,003,084)		143,517

Options on futures, net	—		—		—		—		—		(779)
Interest rate lock commitments	—		—		—		—		—		—
Forward mortgage loan sale commitments	—		—		—		—		—		—
Total	$	5,383,706	$	3,194,493	$	(5,737,177)	$	2,841,022	$	4,568,757	$	48,704


	Nine Months Ended September 30, 2024
(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	$	163,735	$	—	$	(21,724)	$	142,011	$	153,181	$	—
Interest rate swap agreements	17,788,114		24,147,143		(27,738,052)		14,197,205		13,290,306		(69,934)


Swaptions, net	(200,000)		(500,000)		700,000		—		(77,372)		(98)
TBAs, net	3,497,000		42,967,000		(41,400,000)		5,064,000		4,046,869		65,576


Futures, net	(6,203,050)		(19,067,500)		21,576,650		(3,693,900)		(5,937,450)		(89,537)


Options on futures, net	—		—		—		—		—		(127)
Interest rate lock commitments	—		82,806		(49,425)		33,381		14,204		—
Forward mortgage loan sale commitments	—		82,806		(46,408)		36,398		14,253		—
Total	$	15,045,799	$	47,712,255	$	(46,978,959)	$	15,779,095	$	11,503,991	$	(94,120)


	Nine Months Ended September 30, 2023
(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	$	196,456	$	—	$	(24,949)	$	171,507	$	184,172	$	—
Interest rate swap agreements	—		11,873,556		(3,327,591)		8,545,965		6,874,280		(23,676)


Swaptions, net	—		(400,000)		200,000		(200,000)		(148,718)		(80)
TBAs, net	3,826,000		35,490,000		(37,122,000)		2,194,000		3,394,330		(194,716)


Futures, net	(18,285,452)		(29,619,130)		40,034,132		(7,870,450)		(9,637,688)		123,547


Options on futures, net	—		—		—		—		—		(779)
Interest rate lock commitments	—		—		—		—		—		—
Forward mortgage loan sale commitments	—		—		—		—		—		—
Total	$	(14,262,996)	$	17,344,426	$	(240,408)	$	2,841,022	$	666,376	$	(95,704)

____________________

(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 condensed consolidated statements of cash flows. Realized gains and losses and derivative fair value adjustments are reflected within the realized and unrealized loss (gain) on interest rate swaps and swaptions, unrealized gains on other derivative instruments and gains on mortgage loans held-for-sale line items within the operating activities section of the condensed consolidated statements of cash flows. The remaining cash flow activity related to derivative instruments is reflected within the short sales (purchases) of derivative instruments, net; (payments for termination and settlement) proceeds from sales and settlement of derivative instruments, net; and decrease in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.

Interest Rate Sensitive Assets/Liabilities

The Company’s Agency RMBS portfolio is generally subject to change in value when interest rates or prepayment speeds decrease or increase, depending on the type of investment. Periods of rising interest rates with corresponding decreasing prepayment speeds generally result in a decline in the value of the Company’s fixed-rate Agency principal and interest (P&I) RMBS. The impact of this effect on the Company’s fixed-rate Agency P&I RMBS portfolio is partially mitigated by the presence of fixed-rate interest-only Agency RMBS, which generally increase in value when prepayment speeds decrease and MSR, which generally increase in value when prepayment speeds decrease and interest rates increase. As of September 30, 2024 and December 31, 2023, the Company had $17.4 million and $41.9 million, respectively, of interest-only securities, and $2.9 billion and $3.1 billion, respectively, of MSR. Interest-only securities are included in AFS securities, at fair value, in the condensed consolidated balance sheets.

The Company monitors its borrowings under repurchase agreements and revolving credit facilities, which are generally floating-rate debt, in relation to the rate profile of its portfolio. In connection with its risk management activities, the Company enters into a variety of derivative and non-derivative instruments to economically hedge interest rate risk or duration mismatch (or gap) by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (e.g., OIS or SOFR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration. To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio, its cash flows and its loan origination pipeline (consisting of IRLCs and mortgage loans held-for-sale), the Company may, at times, enter into various forward contracts, including short securities, TBAs, options, futures, swaps, caps, credit default swaps, total return swaps and forward mortgage loan sale commitments. In executing on the Company’s current interest rate risk management strategy, the Company has entered into TBAs, interest rate swap and swaption agreements, futures, options on futures and forward mortgage loan sale commitments.

TBAs. The Company may use TBAs as a means of deploying capital until targeted investments are available or to take advantage of temporary displacements, funding advantages or valuation differentials 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. 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.

The Company may hold both long and short notional TBA positions, which are disclosed 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 September 30, 2024 and December 31, 2023:


	September 30, 2024
							Net Carrying Value (4)
(in thousands)	Notional Amount (1)		Cost Basis (2)		Market Value (3)		Derivative Assets		Derivative Liabilities
Purchase contracts	$	5,098,000	$	5,092,267	$	5,075,542	$	—	$	(16,725)
Sale contracts	(34,000)		(31,850)		(31,665)		185		—
TBAs, net	$	5,064,000	$	5,060,417	$	5,043,877	$	185	$	(16,725)


	December 31, 2023
							Net Carrying Value (4)
(in thousands)	Notional Amount (1)		Cost Basis (2)		Market Value (3)		Derivative Assets		Derivative Liabilities
Purchase contracts	$	4,194,000	$	3,827,271	$	3,898,874	$	72,980	$	(1,377)
Sale contracts	(697,000)		(656,723)		(676,852)		—		(20,129)
TBAs, net	$	3,497,000	$	3,170,548	$	3,222,022	$	72,980	$	(21,506)

___________________

(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 condensed consolidated balance sheets.

Futures. The Company may use a variety of types of futures independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The following table summarizes certain characteristics of the Company’s futures as of September 30, 2024 and December 31, 2023:


(dollars in thousands)	September 30, 2024					December 31, 2023
Type & Maturity	Notional Amount		Carrying Value		Weighted Average Months to Expiration	Notional Amount		Carrying Value		Weighted Average Months to Expiration
U.S. Treasury futures - 2 year	$	(2,028,200)	$	—	3.03	$	(549,600)	$	—	2.89
U.S. Treasury futures - 5 year	(749,400)		—		3.03	(1,876,700)		—		2.89
U.S. Treasury futures - 10 year	(561,900)		—		2.63	(983,300)		—		2.60
U.S. Treasury futures - 20 year	425,600		—		2.63	(388,200)		—		2.89
Eris SOFR swap futures - 10 year	(30,000)		—		122.66	—		—		—
SOFR futures
≤ 1 year	(750,000)		—		7.05	(1,842,750)		—		6.05
> 1 and ≤ 2 years	—		—		—	(562,500)		—		17.56

Total futures	$	(3,693,900)	$	—	4.30	$	(6,203,050)	$	—	5.10

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. As of September 30, 2024 and December 31, 2023, the Company held the following interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) whereby the Company receives interest at a floating interest rate (OIS or SOFR):


(notional in thousands)
September 30, 2024
Swaps Maturities	Notional Amount (1)		Weighted Average Fixed Pay Rate (2)		Weighted Average Receive Rate		Weighted Average Maturity (Years) (2)
≤ 1 year	$	2,647,671	4.730	%	4.960	%	0.46
> 1 and ≤ 3 years	4,505,979		3.929	%	4.960	%	1.75
> 3 and ≤ 5 years	2,718,767		3.546	%	4.960	%	3.28
> 5 and ≤ 7 years	450,866		—	%	—	%	0.00
> 7 and ≤ 10 years	285,182		—	%	—	%	0.00
> 10 years	736,262		3.707	%	4.960	%	13.65
Total	$	11,344,727	4.107	%	4.960	%	2.52


(notional in thousands)
December 31, 2023
Swaps Maturities	Notional Amount (1)		Weighted Average Fixed Pay Rate (2)		Weighted Average Receive Rate		Weighted Average Maturity (Years) (2)
≤ 1 year	$	—	—	%	—	%	0.00
> 1 and ≤ 3 years	6,796,772		4.551	%	5.380	%	1.44
> 3 and ≤ 5 years	2,040,444		3.800	%	5.380	%	4.07
> 5 and ≤ 7 years	697,800		4.282	%	5.380	%	6.67
> 7 and ≤ 10 years	2,125,830		3.606	%	5.380	%	9.32
> 10 years	466,637		3.753	%	5.380	%	14.57
Total	$	12,127,483	4.245	%	5.380	%	3.87

____________________

(1)Notional amount includes $2.5 billion and $1.1 billion in forward starting interest rate swaps as of September 30, 2024 and December 31, 2023, respectively.

(2)Weighted averages exclude forward starting interest rate swaps. As of September 30, 2024 and December 31, 2023, forward starting interest rate swap payers had a weighted average fixed pay rate of 3.3% and 4.0% and weighted average maturities of 5.4 and 6.4 years, respectively.

Additionally, as of September 30, 2024 and December 31, 2023, the Company held the following interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) risk whereby the Company pays interest at a floating interest rate (OIS or SOFR):


(notional in thousands)
September 30, 2024
Swaps Maturities	Notional Amount (1)		Weighted Average Pay Rate		Weighted Average Fixed Receive Rate (2)		Weighted Average Maturity (Years) (2)
≤ 1 year	$	786,641	4.960	%	4.025	%	0.47
> 1 and ≤ 3 years	925,695		4.960	%	3.326	%	3.00
> 3 and ≤ 5 years	352,348		4.960	%	3.099	%	4.96
> 5 and ≤ 7 years	99,607		4.960	%	3.097	%	6.95
> 7 and ≤ 10 years	194,861		4.960	%	3.633	%	9.83
> 10 years	493,326		4.960	%	3.384	%	20.38
Total	$	2,852,478	4.960	%	3.571	%	7.12


(notional in thousands)
December 31, 2023
Swaps Maturities	Notional Amount (1)		Weighted Average Pay Rate		Weighted Average Fixed Receive Rate (2)		Weighted Average Maturity (Years) (2)
≤ 1 year	$	—	—	%	—	%	0.00
> 1 and ≤ 3 years	2,470,819		5.380	%	4.204	%	1.36
> 3 and ≤ 5 years	780,000		5.380	%	3.845	%	1.36
> 5 and ≤ 7 years	988,026		5.380	%	4.023	%	4.03
> 7 and ≤ 10 years	1,161,160		5.380	%	4.013	%	9.57
> 10 years	260,626		5.380	%	3.444	%	20.01
Total	$	5,660,631	5.380	%	4.052	%	5.00

____________________

(1)Notional amount includes $665.7 million and $645.2 million in forward starting interest rate swaps as of September 30, 2024 and December 31, 2023, respectively.

(2)Weighted averages exclude forward starting interest rate swaps. As of September 30, 2024 and December 31, 2023, forward starting interest rate swap receivers had a weighted average fixed receive rate of 3.4% and 4.4% and weighted average maturities of 2.0 and 2.0 years, respectively.

Interest Rate Swaptions. The Company may use interest rate swaptions (which provide the option to enter into interest rate swap agreements for a predetermined notional amount, stated term and pay and receive interest rates in the future) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The Company did not hold any interest rate swaptions as of September 30, 2024. As of December 31, 2023, the Company had the following outstanding interest rate swaptions:


	December 31, 2023
(notional and dollars in thousands)	Option						Underlying Swap
Swaption	Expiration	Cost		Fair Value		Average Months to Expiration	Notional Amount		Average Fixed Rate		Average Term (Years)
Purchase contracts:
Payer	< 6 Months	$	480	$	22	2.40	$	200,000	5.13	%	1.0







Sale contracts:
Payer	< 6 Months	$	(332)	$	(3)	2.40	$	(400,000)	5.61	%	1.0

Interest Rate Lock Commitments. The Company enters into IRLCs to originate residential mortgage loans at specified interest rates and terms within a specified period of time with customers who have applied for a loan and may meet certain credit and underwriting criteria. IRLCs are subject to changes in mortgage interest rates from the date of the commitment through the date of funding the loan or the cancellation or expiration of the lock commitment, generally ranging between 30 and 90 days. IRLCs are considered freestanding derivatives and are recorded at fair value at inception inclusive of the inherent value of servicing the loan. The Company did not hold any IRLCs as of December 31, 2023. As of September 30, 2024, the Company had outstanding IRLCs of $33.4 million in principal with a net fair value of $0.5 million.

Forward Mortgage Loan Sale Commitments. The Company uses forward mortgage loan sale commitments to manage exposure to interest rate risk and changes in the fair value of IRLCs from the date of the commitment through the date of funding or cancellation or expiration of the lock commitment. Forward mortgage loan sale commitments are also used to manage exposure to interest rate risk and changes in the fair value of the Company’s mortgage loans held-for-sale from the date of funding through the date of sale in the secondary market, typically within 30 days of origination. Forward mortgage loan sale commitments are recorded at fair value based on pricing of similar instruments in the secondary market based upon the investor, coupon, and estimated sale or delivery month. The Company’s expectation of the amount of IRLCs that will ultimately close is a key factor in determining the notional amount of derivatives used in economically hedging the position. The Company did not hold any forward mortgage loan sale commitments as of December 31, 2023. As of September 30, 2024, the Company had outstanding forward mortgage loan sale commitments of $36.4 million in principal with a net fair value of $29 thousand.

Credit Risk

The Company’s exposure to credit losses on its Agency RMBS portfolio is limited due to implicit or explicit backing from either a GSE or a U.S. government agency. 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.

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. The Company also has processes and controls in place to monitor, analyze, manage and mitigate its credit risk with respect to non-Agency securities and mortgage loans held-for-sale.

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 September 30, 2024, the fair value of derivative financial instruments as an asset and liability position was $12.6 million and $16.8 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 internal 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 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. The Company’s centrally cleared interest rate swaps and exchange-traded futures and options on futures require the Company to post an “initial margin” amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the derivative instrument’s maximum estimated single-day price movement. The Company also exchanges “variation margin” based upon daily changes in fair value, as measured by the exchange. The exchange of variation margin is considered a settlement of the derivative instrument, as opposed to pledged collateral. Accordingly, the Company accounts for the receipt or payment of variation margin as a direct reduction to the carrying value of the centrally cleared or exchange-traded derivative asset or liability.