Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities (Notes)

v2.4.0.8
Derivative Instruments and Hedging Activities (Notes)
 3 Months Ended
Mar. 31, 2014
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, put and call options for TBAs, constant maturity swaps, credit default swaps and total return 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.
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. 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 is 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 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.
Balance Sheet Presentation
The following tables present the gross fair value and notional amounts of the Company’s derivative financial instruments treated as trading instruments as of March 31, 2014 and December 31, 2013.
(in thousands)
 
March 31, 2014
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
212,984

 
$
1,412,374

 
$
—

 
$
—

Interest rate swap agreements
 
40,310

 
21,663,148

 
—

 
—

Credit default swaps
 
—

 
—

 
(2,395
)
 
125,000

Swaptions
 
164,296

 
9,500,000

 
—

 
—

TBAs
 
4,331

 
1,100,000

 
(5,487
)
 
2,372,000

Put and call options for TBAs
 
3,627

 
1,500,000

 
—

 
—

Constant maturity swaps
 
3,871

 
10,000,000

 
—

 
—

Total return swaps
 
—

 
—

 
(126
)
 
243,987

Forward purchase commitment
 
—

 
—

 
(387
)
 
153,637

Total
 
$
429,419

 
$
45,175,522

 
$
(8,395
)
 
$
2,894,624


(in thousands)
 
December 31, 2013
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
221,364

 
$
1,525,845

 
$
—

 
$
—

Interest rate swap agreements
 
25,325

 
19,619,000

 
—

 
—

Credit default swaps
 
—

 
—

 
(18,049
)
 
427,073

Swaptions
 
269,745

 
5,130,000

 
—

 
—

TBAs
 
33,425

 
4,097,000

 
(125
)
 
400,000

Constant maturity swaps
 
—

 
—

 
(3,773
)
 
10,000,000

Total return swaps
 
—

 
—

 
(134
)
 
49,629

Forward purchase commitment
 
—

 
12,063

 
—

 
—

Total
 
$
549,859

 
$
30,383,908

 
$
(22,081
)
 
$
10,876,702



The following table provides the average outstanding notional amounts of the Company’s derivative financial instruments treated as trading instruments for the three months ended March 31, 2014.
(in thousands)
 
Three Months Ended March 31, 2014
Trading instruments
 
Derivative Assets
 
Derivative Liabilities
Inverse interest-only securities
 
$
1,470,667

 
$
—

Interest rate swap agreements
 
19,156,878

 
—

Credit default swaps
 
—

 
179,418

Swaptions
 
8,979,111

 
—

TBAs
 
1,289,500

 
1,815,944

Put and call options for TBAs
 
255,556

 
—

Constant maturity swaps
 
10,000,000

 
—

Total return swaps
 
—

 
153,910

Forward purchase commitment
 
—

 
38,913



Comprehensive Income Statement Presentation
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.
The following table summarizes the location and amount of gains and losses on derivative instruments reported in the condensed consolidated statements of comprehensive 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
 
 
 
 
Three Months Ended March 31,
 
 
 
 
2014
 
2013
Interest rate risk management
 
 
 
 
 
 
TBAs (1)
 
Gain (loss) on other derivative instruments
 
$
(17,903
)
 
$
(12,652
)
Put and call options for TBAs (1)
 
Gain (loss) on other derivative instruments
 
(1,705
)
 
—

Constant maturity swaps (1)
 
Gain (loss) on other derivative instruments
 
11,531

 
—

Interest rate swap agreements - Receivers (1)
 
(Loss) gain on interest rate swap and swaption agreements
 
16,566

 
—

Interest rate swap agreements - Payers (1)
 
(Loss) gain on interest rate swap and swaption agreements
 
(6,776
)
 
—

Total return swaps (2)
 
Gain (loss) on other derivative instruments
 
(1,725
)
 
—

Interest rate swap agreements - Receivers (2)
 
(Loss) gain on interest rate swap and swaption agreements
 
24,413

 
—

Interest rate swap agreements - Payers (2)
 
(Loss) gain on interest rate swap and swaption agreements
 
(6,644
)
 
(89
)
Interest rate swap agreements - Payers (3)
 
(Loss) gain on interest rate swap and swaption agreements
 
(20,529
)
 
1,090

Swaptions (3)
 
(Loss) gain on interest rate swap and swaption agreements
 
(112,558
)
 
17,971

Credit risk management
 
 
 
 
 
 
Credit default swaps - Receive protection (4)
 
Gain (loss) on other derivative instruments
 
1,981

 
(5,643
)
Non-risk management
 
 
 
 
 
 
TBAs
 
Gain (loss) on other derivative instruments
 
(4,701
)
 
403

Inverse interest-only securities
 
Gain (loss) on other derivative instruments
 
18,323

 
1,230

Forward purchase commitments
 
(Loss) gain on mortgage loans held-for-sale
 
(417
)
 
287

Total
 
 
 
$
(100,144
)
 
$
2,597


____________________
(1)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s AFS securities, mortgage loans held-for-sale and forward purchase commitments.
(2)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s U.S. Treasuries, TBAs and MSR.
(3)
Includes derivative instruments held to mitigate interest rate risk associated with the Company’s repurchase agreements and FHLB advances.
(4)
Includes derivative instruments held to mitigate credit risk associated with the Company’s non-Agency RMBS and mortgage loans held-for-sale.

For the three months ended March 31, 2014 and 2013, the Company recognized $13.8 million and $14.0 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 generally paying a fixed interest rate on an average $19.2 billion and $14.9 billion notional, respectively, to economically hedge a portion of the Company’s interest rate risk on its short-term repurchase agreements, funding costs, and macro-financing risk and generally receiving LIBOR interest.
For the three months ended March 31, 2014 and 2013, the Company terminated, had agreements mature or had options expire on a total of 7 and 69 interest rate swap and swaption positions of $3.0 billion and $8.2 billion notional, respectively. Upon settlement of the early terminations, contractual maturities and option expirations, the Company paid $0.9 million and $17.2 million in full settlement of its net interest spread liability and recognized $1.2 million and $58.7 million in realized losses on the swaps and swaptions for the three months ended March 31, 2014 and 2013, respectively, including early termination penalties.
For the three months ended March 31, 2014, the Company terminated or had agreements mature on three credit default swap positions of $305.0 million notional. Upon settlement of the early terminations, the Company paid $1.2 million in full settlement of its net interest spread liability and recognized $13.7 million, in realized losses on the credit default swaps for the three months ended March 31, 2014, including early terminations penalties. For the three months ended March 31, 2013, the Company did not terminate any credit default swap positions.
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. Derivative fair value adjustments are reflected within the unrealized loss (gain) on interest rate swaps and swaptions, unrealized loss on other derivative instruments, and loss (gain) on mortgage loans held-for-sale line items within the operating activities section of the condensed consolidated statements of cash flows. Realized losses on interest rate swap and swaption agreements are reflected within the loss on termination of interest rate swaps and swaptions line item 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 purchases of other derivative instruments, proceeds from sales of other derivative instruments, and (decrease)/increase 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
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, put and call options for TBAs, constant maturity swaps and interest rate swap agreements to further mitigate its exposure to higher interest rates, decreased prepayment speeds and widening mortgage spreads. The objective is to reduce the risk of losses to the portfolio caused by interest rate changes and changes in prepayment speeds.
As of March 31, 2014 and December 31, 2013, the Company had outstanding fair value of $72.2 million and $75.6 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.
As of March 31, 2014, $1.2 billion of the Company’s long notional TBA positions and $2.2 billion of the Company’s short notional TBA positions were held as a means to mitigate exposure to higher interest rates and wider mortgage spreads. As of December 31, 2013, $0.4 billion of the Company’s long notional TBA positions and $1.9 billion of the Company’s short notional TBA positions were held as a means to mitigate exposure to higher interest rates and wider mortgage spreads, while the remaining $2.2 billion long notional TBA positions were held for non-risk management purposes (see discussion of “Non-Risk Management Activities” below). 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 March 31, 2014 and December 31, 2013:
 
As of March 31, 2014
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
1,225,000

 
$
1,183,028

 
$
1,186,866

 
$
4,331

 
$
(493
)
Sale contracts
(2,247,000
)
 
(2,269,600
)
 
(2,274,594
)
 
—

 
(4,994
)
TBAs, net
$
(1,022,000
)
 
$
(1,086,572
)
 
$
(1,087,728
)
 
$
4,331

 
$
(5,487
)
 
As of December 31, 2013
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
2,550,000

 
$
2,749,648

 
$
2,767,295

 
$
17,771

 
$
(125
)
Sale contracts
(1,947,000
)
 
(1,959,256
)
 
(1,943,602
)
 
15,654

 
—

TBAs, net
$
603,000

 
$
790,392

 
$
823,693

 
$
33,425

 
$
(125
)
___________________
(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.

As of March 31, 2014, the Company had purchased put and call options for TBAs with a total notional amount of $1.5 billion. The Company paid upfront premiums of approximately $5.3 million for the options purchased. Each of the options will expire by September 2014. The put and call options had a net fair market value of $3.6 million, included in derivative assets, at fair value, in the condensed consolidated balance sheet as of March 31, 2014. The Company did not hold any put or call options for TBAs as of December 31, 2013.
The Company has also entered into constant maturity swaps between the 10-year interest rate swap curve and the yield to maturity on a 30-year Fannie Mae TBA to economically hedge mortgage spread widening. The Company had the following constant maturity swap agreements in place at March 31, 2014 and December 31, 2013:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
March 31, 2014
Determination Date
 
Average Strike Swap Rate
 
Notional Amount
 
Fair Value
 
Upfront Premium Paid
 
Unrealized Gain/(Loss)
May 2014
 
0.670
%
 
3,000,000

 
872

 
—

 
872

June 2014
 
0.846
%
 
5,000,000

 
2,167

 
—

 
2,167

September 2014
 
0.847
%
 
2,000,000

 
832

 
—

 
832

Total
 
0.793
%
 
$
10,000,000

 
$
3,871

 
$
—

 
$
3,871

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2013
Determination Date
 
Average Strike Swap Rate
 
Notional Amount
 
Fair Value
 
Upfront Premium Paid
 
Unrealized Gain/(Loss)
February 2014
 
0.768
%
 
3,000,000

 
625

 
—

 
625

March 2014
 
0.850
%
 
5,000,000

 
(3,171
)
 
—

 
(3,171
)
June 2014
 
0.828
%
 
2,000,000

 
(1,227
)
 
—

 
(1,227
)
Total
 
0.821
%
 
$
10,000,000

 
$
(3,773
)
 
$
—

 
$
(3,773
)


As of March 31, 2014 and December 31, 2013, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk associated with the Company’s AFS securities whereby the Company receives interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
March 31, 2014
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2018 and Thereafter
 
$
1,920,000

 
1.946
%
 
0.235
%
 
5.77

Total
 
$
1,920,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2013
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2018
 
$
2,040,000

 
1.563
%
 
0.241
%
 
4.94

Total
 
$
2,040,000

 
 
 
 
 
 


Additionally, as of March 31, 2014 and December 31, 2013, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk associated with the Company’s AFS securities whereby the Company pays interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
March 31, 2014
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2018 and Thereafter
 
$
1,494,148

 
0.235
%
 
2.463
%
 
7.83

Total
 
$
1,494,148

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2013
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2023
 
$
1,099,000

 
0.242
%
 
2.914
%
 
9.94

Total
 
$
1,099,000

 
 
 
 
 
 


U.S. Treasuries, TBAs and MSR - The Company has entered into interest rate swaps in combination with U.S. Treasuries, TBAs and MSR to economically hedge funding cost risk, mortgage interest rate exposure (or duration), and mortgage basis widening, depending on the type of investment.
As of March 31, 2014 and December 31, 2013, the Company held $1.0 billion and $1.0 billion, respectively, in fair value of U.S. Treasuries classified as trading securities and the following outstanding interest rate swaps utilized to economically hedge funding cost risk:
(notional in thousands)
 
 
 
 
 
 
March 31, 2014
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2016
 
$
1,000,000

 
0.955
%
 
0.233
%
 
2.42

Total
 
$
1,000,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2013
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2016
 
$
1,000,000

 
0.955
%
 
0.239
%
 
2.67

Total
 
$
1,000,000

 
 
 
 
 
 


As of March 31, 2014, the Company held the following interest rate swaps entered in combination with TBA contracts and/or MSR to economically hedge mortgage basis widening and duration whereby the Company receives interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
March 31, 2014
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2018
 
$
1,020,000

 
1.560
%
 
0.235
%
 
4.69

Total
 
$
1,020,000

 
 
 
 
 
 

The Company did not hold any interest rate swaps in connection with TBA contracts and/or MSR whereby the Company receives interest at a three-month LIBOR rate at December 31, 2013.
As of March 31, 2014 and December 31, 2013, the Company held the following interest rate swaps entered in combination with TBA contracts and/or MSR to economically hedge mortgage basis widening and duration whereby the Company pays interest at a three-month LIBOR rate:
(notional in thousands)
 
 
 
 
 
 
March 31, 2014
Swaps Maturities
 
Notional Amount
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2018 and Thereafter
 
1,604,000

 
0.235
%
 
2.134
%
 
6.87

Total
 
$
1,604,000

 
 
 
 
 
 
(notional in thousands)
 
 
 
 
 
 
December 31, 2013
Swaps Maturities
 
Notional Amount
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2018 and Thereafter
 
$
1,055,000

 
0.239
%
 
1.736
%
 
5.65

Total
 
$
1,055,000

 
 
 
 
 
 

The Company also enters into total return swaps (agreements whereby the Company receives or makes payments based on the total return of an underlying instrument or index in exchange for fixed or floating rate interest payments) to economically hedge negative convexity and spread duration of MSR. The Company had the following total return swap agreements in place at March 31, 2014 and December 31, 2013:
(notional and dollars in thousands)
 
 
 
 
 
March 31, 2014
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
1/12/2043
 
(243,987
)
 
(126
)
 
(1,430
)
 
(1,556
)
Total
 
$
(243,987
)
 
$
(126
)
 
$
(1,430
)
 
$
(1,556
)
(notional and dollars in thousands)
 
 
 
 
 
December 31, 2013
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain/(Loss)
1/12/2043
 
(49,629
)
 
(134
)
 
(453
)
 
(587
)
Total
 
$
(49,629
)
 
$
(134
)
 
$
(453
)
 
$
(587
)


Commitments to Purchase and/or Sell 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 balance sheet as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the balance sheet as adjustments to the carrying value of these assets or liabilities with a corresponding adjustment recognized in current period earnings. As of March 31, 2014 and December 31, 2013, the Company had outstanding commitments to purchase $153.6 million and $12.1 million of mortgage loans, subject to fallout if the loans do not close, with a fair value liability of $0.4 million at March 31, 2014. As of December 31, 2013, no fair value was assigned to the derivative as there was not a meaningful change in market value from commitment date to December 31, 2013.
The Company is exposed to interest rate risk on mortgage loans from the time it commits to purchase the 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 mortgage loans held-for-sale increases, and vice versa. To mitigate the impact of this risk, the Company may from time to time enter into a forward sale commitment under the Forward AAA Securities Agreement, or the Forward Agreement, with Barclays Bank PLC, or Barclays, pursuant to which Barclays would purchase certain securities issued in connection with a potential securitization transaction involving mortgage loans subject to the Forward Agreement. As of March 31, 2014 and December 31, 2013, the Company did not have any trades under the Forward Agreement. The Company may also enter into other derivative contracts to hedge the interest rate risk related to the commitments to purchase mortgage loans, such as interest rate swaps, swaptions, TBA positions, put and call options for TBAs or constant maturity swaps.
Repurchase Agreements and FHLB Advances - The Company monitors its 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 investment securities and debt portfolios, specifically repurchase agreements with maturities 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 from floating to fixed.
As of March 31, 2014 and December 31, 2013, 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:
(notional in thousands)
 
 
 
 
 
 
March 31, 2014
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2014
 
$
3,000,000

 
0.295
%
 
0.234
%
 
0.73

2015
 
1,000,000

 
0.383
%
 
0.237
%
 
0.79

2016
 
2,950,000

 
0.626
%
 
0.238
%
 
2.17

2017
 
6,300,000

 
0.936
%
 
0.236
%
 
3.20

2018 and Thereafter
 
1,375,000

 
1.424
%
 
0.235
%
 
4.80

Total
 
$
14,625,000

 
0.750
%
 
0.236
%
 
2.47

(notional in thousands)
 
 
 
 
 
 
December 31, 2013
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2014
 
$
3,900,000

 
0.300
%
 
0.245
%
 
0.76

2015
 
1,000,000

 
0.383
%
 
0.244
%
 
1.04

2016
 
2,950,000

 
0.626
%
 
0.246
%
 
2.42

2017
 
5,300,000

 
0.920
%
 
0.217
%
 
3.49

2018 and Thereafter
 
1,275,000

 
1.406
%
 
0.242
%
 
5.04

Total
 
$
14,425,000

 
0.698
%
 
0.235
%
 
2.50



As of March 31, 2014 and December 31, 2013, the Company had the following outstanding 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) that were utilized as macro-economic hedges:
March 31, 2014
(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
 
$
9,090

 
$
1,325

 
2.29
 
$
800,000

 
3.56
%
 
3M Libor
 
10.0

Payer
 
≥ 6 Months
 
223,504

 
219,922

 
36.49
 
6,000,000

 
4.27
%
 
3M Libor
 
9.0

Total Payer
 
 
 
$
232,594

 
$
221,247

 
36.19
 
$
6,800,000

 
4.19
%
 
3M Libor
 
9.1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
6,038

 
$
3,939

 
3.23
 
$
2,000,000

 
3M Libor
 
1.68
%
 
5.0

Receiver
 
≥ 6 Months
 
900

 
522

 
9.30
 
2,000,000

 
3M Libor
 
1.08
%
 
5.0

Total Receiver
 
 
 
$
6,938

 
$
4,461

 
4.51
 
$
4,000,000

 
3M Libor
 
1.38
%
 
5.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
≥ 6 Months
 
(81,248
)
 
(58,645
)
 
39.02
 
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(81,248
)
 
$
(58,645
)
 
39.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
(2,625
)
 
$
(2,767
)
 
2.30
 
$
(500,000
)
 
3M Libor
 
3.20
%
 
10.0

Total Receiver
 
 
 
$
(2,625
)
 
$
(2,767
)
 
2.30
 
$
(500,000
)
 
3M Libor
 
3.20
%
 
10.0

December 31, 2013
(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
 
$
10,431

 
$
10,458

 
2.78
 
$
675,000

 
3.33
%
 
3M Libor
 
10.0

Payer
 
≥ 6 Months
 
223,504

 
353,108

 
39.14
 
6,000,000

 
4.27
%
 
3M Libor
 
9.0

Total Payer
 
 
 
$
233,935

 
$
363,566

 
38.16
 
$
6,675,000

 
4.18
%
 
3M Libor
 
9.1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
3,991

 
$
681

 
1.93
 
$
275,000

 
3M Libor
 
2.89
%
 
10.0

Total Receiver
 
 
 
$
3,991

 
$
681

 
1.93
 
$
275,000

 
3M Libor
 
2.89
%
 
10.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
< 6 Months
 
$
(3,455
)
 
$
(7,679
)
 
1.93
 
$
(510,000
)
 
1.60
%
 
3M Libor
 
5.0

Payer
 
≥ 6 Months
 
(81,248
)
 
(86,361
)
 
42.02
 
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(84,703
)
 
$
(94,040
)
 
33.68
 
$
(1,310,000
)
 
2.72
%
 
3M Libor
 
8.1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Receiver
 
< 6 Months
 
$
(3,455
)
 
$
(462
)
 
1.93
 
$
(510,000
)
 
3M Libor
 
1.60
%
 
5.0

Total Receiver
 
 
 
$
(3,455
)
 
$
(462
)
 
1.93
 
$
(510,000
)
 
3M Libor
 
1.60
%
 
5.0



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.
Credit Risk
The Company’s exposure to credit losses on its U.S. Treasuries and Agency portfolio of investment securities is limited because these securities are issued by the U.S. Department of the Treasury or 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.
For non-Agency investment securities and mortgage loans, 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 of “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 and mortgage loans.
As of March 31, 2014, the Company held credit default swaps whereby 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 tables present credit default swaps whereby the Company is receiving protection held as of March 31, 2014 and December 31, 2013:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
March 31, 2014
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront (Payable)/Receivable
 
Unrealized Gain/(Loss)
Receive
6/20/2016
 
105.50

 
(100,000
)
 
(2,045
)
 
(260
)
 
(2,305
)
 
12/20/2016
 
496.00

 
(25,000
)
 
(350
)
 
(4,062
)
 
(4,412
)
 
Total
 
183.60

 
$
(125,000
)
 
$
(2,395
)
 
$
(4,322
)
 
$
(6,717
)

(notional and dollars in thousands)
 
 
 
 
 
 
 
 
December 31, 2013
Protection
Maturity Date
 
Average Implied Credit Spread
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain/(Loss)
Receive
6/20/2016
 
105.50

 
(100,000
)
 
(2,149
)
 
(260
)
 
(2,409
)
 
12/20/2016
 
496.00

 
(25,000
)
 
(401
)
 
(4,062
)
 
(4,463
)
 
12/20/2018
 
393.31

 
(270,000
)
 
(23,568
)
 
12,838

 
(10,730
)
 
5/25/2046
 
356.00

 
(32,073
)
 
8,069

 
(15,026
)
 
(6,957
)
 
Total
 
329.13

 
$
(427,073
)
 
$
(18,049
)
 
$
(6,510
)
 
$
(24,559
)

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 March 31, 2014, the fair value of derivative financial instruments as an asset and liability position was $429.4 million and $8.4 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; the Company also 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 March 31, 2014, the Company has received cash deposits from counterparties of $148.3 million and placed cash deposits of $127.6 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, Derivatives and Hedging, as amended and interpreted, or ASC 815, 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 RMBS, forward purchase commitments and TBAs. As of December 31, 2013, the Company held $2.2 billion notional TBAs as a means of deploying capital until targeted investments are available, and to take advantage of temporary displacements in the marketplace. None of the Company’s TBAs were held for this purpose as of March 31, 2014.
As of March 31, 2014 and December 31, 2013, inverse interest-only securities with a carrying value of $213.0 million and $221.4 million, including accrued interest receivable of $2.7 million and $2.9 million, respectively, 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 March 31, 2014 and December 31, 2013:
(in thousands)
March 31,
2014
 
December 31,
2013
Face Value
$
1,412,374

 
$
1,525,845

Unamortized premium
—

 
—

Unamortized discount
 
 
 
Designated credit reserve
—

 
—

Net, unamortized
(1,198,616
)
 
(1,292,785
)
Amortized Cost
213,758

 
233,060

Gross unrealized gains
9,014

 
5,891

Gross unrealized losses
(12,441
)
 
(20,442
)
Carrying Value
$
210,331

 
$
218,509