Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities (Notes)

v3.4.0.3
Derivative Instruments and Hedging Activities (Notes)
 3 Months Ended
Mar. 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. 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 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 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 March 31, 2016 and December 31, 2015.
(in thousands)
 
March 31, 2016
 
 
Derivative Assets
 
Derivative Liabilities
Trading instruments
 
Fair Value
 
Notional
 
Fair Value
 
Notional
Inverse interest-only securities
 
$
158,786

 
$
882,726

 
$
—

 
$
—

Interest rate swap agreements
 
18,162

 
8,865,513

 
(65,715
)
 
6,560,000

Credit default swaps
 
—

 
—

 
(390
)
 
125,000

Swaptions, net
 
10,482

 
3,700,000

 
(473
)
 
1,500,000

TBAs
 
9,557

 
2,187,000

 
(3,328
)
 
550,000

Put and call options for TBAs, net
 
366

 
2,000,000

 
—

 
—

Markit IOS total return swaps
 
—

 
—

 
(7,120
)
 
868,145

Forward purchase commitments
 
494

 
234,259

 
(12
)
 
17,953

Total
 
$
197,847

 
$
17,869,498

 
$
(77,038
)
 
$
9,621,098


(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 (Loss) Income 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 condensed consolidated statements of comprehensive (loss) income on the Company’s derivative trading instruments:
Trading Instruments
 
Location of Gain (Loss) Recognized in Income on Derivatives
 
Amount of Gain (Loss) Recognized in Income on Derivatives
(in thousands)
 
 
 
Three Months Ended
March 31,
 
 
 
 
2016
 
2015
Interest rate risk management
 
 
 
 
 
 
TBAs (1)
 
Gain on other derivative instruments
 
$
25,329

 
$
(27,958
)
Put and call options for TBAs (1)
 
Gain on other derivative instruments
 
(981
)
 
2,535

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

 
6,090

Interest rate swap agreements - Receivers (1)
 
Loss on interest rate swap and swaption agreements
 
112,674

 
42,326

Interest rate swap agreements - Payers (1)
 
Loss on interest rate swap and swaption agreements
 
(81,084
)
 
(52,559
)
Swaptions (1)
 
Loss on interest rate swap and swaption agreements
 
(16,255
)
 
(18,506
)
Markit IOS total return swaps (1)
 
Gain on other derivative instruments
 
(21,724
)
 
3,132

Interest rate swap agreements - Payers (2)
 
Loss on interest rate swap and swaption agreements
 
(140,819
)
 
(97,704
)
Credit risk management
 
 
 
 
 
 
Credit default swaps - Receive protection (3)
 
Gain on other derivative instruments
 
409

 
(93
)
Non-risk management
 
 
 
 
 
 
Inverse interest-only securities
 
Gain on other derivative instruments
 
12,982

 
19,261

Forward purchase commitments
 
Gain on residential mortgage loans held-for-sale
 
1,398

 
970

Total
 
 
 
$
(108,071
)
 
$
(122,506
)

____________________
(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 three months ended March 31, 2016 and 2015, the Company recognized $6.2 million and $27.5 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 $15.0 billion and $18.2 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 three months ended March 31, 2016 and 2015:
 
Three Months Ended March 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

 
$
—

 
$
(49,311
)
 
$
882,726

 
$
909,378

 
$
—

Interest rate swap agreements
14,268,806

 
6,837,513

 
(5,680,806
)
 
15,425,513

 
14,954,600

 
32,599

Credit default swaps
125,000

 
10,000

 
(10,000
)
 
125,000

 
126,429

 
412

Swaptions, net
5,200,000

 
2,000,000

 
(2,000,000
)
 
5,200,000

 
5,216,484

 
(1,970
)
TBAs, net
297,000

 
4,315,000

 
(2,975,000
)
 
1,637,000

 
153,209

 
18,850

Put and call options for TBAs, net
—

 
2,000,000

 
—

 
2,000,000

 
82,418

 
—

Markit IOS total return swaps
889,418

 
—

 
(21,273
)
 
868,145

 
874,735

 
—

Forward purchase commitments
286,120

 
383,449

 
(417,357
)
 
252,212

 
257,726

 
566

Total
$
21,998,381

 
$
15,545,962

 
$
(11,153,747
)
 
$
26,390,596

 
$
22,574,979

 
$
50,457

 
Three Months Ended March 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

 
$
—

 
$
(62,016
)
 
$
1,106,210

 
$
1,138,468

 
$
—

Interest rate swap agreements
18,584,000

 
5,620,000

 
(4,275,000
)
 
19,929,000

 
18,238,389

 
(1,070
)
Credit default swaps
125,000

 
—

 
—

 
125,000

 
125,000

 
—

Swaptions, net
12,410,000

 
5,550,000

 
(5,000,000
)
 
12,960,000

 
12,851,667

 
12,845

TBAs, net
(1,325,000
)
 
(6,933,000
)
 
5,762,000

 
(2,496,000
)
 
2,121,700

 
(17,364
)
Put and call options for TBAs, net
2,000,000

 
250,000

 
(4,750,000
)
 
(2,500,000
)
 
8,333

 
(3,047
)
Constant maturity swaps
14,000,000

 
6,000,000

 
(17,000,000
)
 
3,000,000

 
6,988,889

 
6,384

Markit IOS total return swaps
598,459

 
676,633

 
(397,563
)
 
877,529

 
875,346

 
4,202

Forward purchase commitments
554,838

 
1,128,634

 
(976,168
)
 
707,304

 
648,343

 
943

Total
$
48,115,523

 
$
12,292,267

 
$
(26,698,747
)
 
$
33,709,043

 
$
42,996,135

 
$
2,893

____________________
(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. Derivative fair value adjustments are reflected within the unrealized 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 condensed consolidated statements of cash flows. Realized gains and losses on interest rate swap and swaption agreements are reflected within the gain on termination and option expiration 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 short sales and purchases of other derivative instruments, proceeds from sales of other derivative instruments, net 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
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 March 31, 2016 and December 31, 2015, the Company had outstanding fair value of $39.1 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 condensed 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. 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 March 31, 2016, $2.2 billion 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. 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 March 31, 2016 and December 31, 2015:
 
As of March 31, 2016
 
 
 
 
 
 
 
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
 
Cost Basis (2)
 
Market Value (3)
 
Derivative Assets
 
Derivative Liabilities
Purchase contracts
$
2,187,000

 
$
2,239,170

 
$
2,248,727

 
$
9,557

 
$
—

Sale contracts
(550,000
)
 
(575,578
)
 
(578,906
)
 
—

 
(3,328
)
TBAs, net
$
1,637,000

 
$
1,663,592

 
$
1,669,821

 
$
9,557

 
$
(3,328
)
 
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 condensed consolidated balance sheets.

Put and Call Options for TBAs. As of March 31, 2016, the Company had purchased put options for TBAs with a notional amount of $2.0 billion and paid upfront premiums of approximately $1.3 million. Each of the options expires in May 2016. The put and call options had a net fair market value of $0.4 million included in derivative assets, at fair value, in the condensed consolidated balance sheet as of March 31, 2016.The Company did not hold any put and call options for TBAs as of December 31, 2015.
Interest Rate Swap Agreements. As of March 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)
 
 
 
 
 
 
March 31, 2016
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
2018
 
$
4,165,000

 
1.298
%
 
0.638
%
 
2.32

2020 and Thereafter
 
1,210,000

 
2.164
%
 
0.627
%
 
4.83

Total
 
$
5,375,000

 
1.493
%
 
0.635
%
 
2.89

(notional in thousands)
 
 
 
 
 
 
December 31, 2015
Swaps Maturities
 
Notional Amounts
 
Average Fixed Pay Rate
 
Average Receive Rate
 
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 March 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)
 
 
 
 
 
 
March 31, 2016
Swaps Maturities
 
Notional Amounts
 
Average Pay Rate
 
Average Fixed Receive Rate
 
Average Maturity (Years)
2018
 
$
575,000

 
0.618
%
 
1.440
%
 
2.64

2019
 
500,000

 
0.621
%
 
1.042
%
 
2.81

2020 and Thereafter
 
2,415,513

 
0.624
%
 
1.938
%
 
6.05

Total
 
$
3,490,513

 
0.623
%
 
1.728
%
 
5.03

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

 
0.462
%
 
0.624
%
 
0.48

2017
 
2,375,000

 
0.765
%
 
0.620
%
 
1.34

2018
 
300,000

 
0.984
%
 
0.617
%
 
1.83

2019
 
350,000

 
1.283
%
 
0.623
%
 
3.19

2020 and Thereafter
 
1,835,000

 
1.797
%
 
0.622
%
 
7.54

Total
 
$
6,560,000

 
1.013
%
 
0.622
%
 
2.98

(notional in thousands)
 
 
 
 
 
 
December 31, 2015
Swaps Maturities
 
Notional Amount
 
Average Fixed Pay Rate
 
Average Receive Rate
 
Average Maturity (Years)
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



Interest Rate Swaptions. As of March 31, 2016 and December 31, 2015, 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, 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
 
$
12,025

 
$
3,682

 
3.71
 
$
1,500,000

 
3.25
%
 
3M Libor
 
10.0

Payer
 
≥ 6 Months
 
126,273

 
7,942

 
40.35
 
4,500,000

 
3.69
%
 
3M Libor
 
5.8

Total Payer
 
 
 
$
138,298

 
$
11,624

 
27.51
 
$
6,000,000

 
3.58
%
 
3M Libor
 
6.8

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sale contracts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Payer
 
≥ 6 Months
 
$
(81,248
)
 
$
(1,615
)
 
15.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

Total Payer
 
 
 
$
(81,248
)
 
$
(1,615
)
 
15.02
 
$
(800,000
)
 
3.44
%
 
3M Libor
 
10.0

 
 
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 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, such as the Markit IOS Index, in exchange for fixed or floating rate interest payments) 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 March 31, 2016 and December 31, 2015:
(notional and dollars in thousands)
 
 
 
 
 
March 31, 2016
Maturity Date
 
Current Notional Amount
 
Fair Value
 
Upfront Payable
 
Unrealized Gain (Loss)
January 12, 2043
 
$
(361,370
)
 
$
(2,494
)
 
$
(866
)
 
$
(3,360
)
January 12, 2044
 
(317,908
)
 
(2,045
)
 
(1,679
)
 
(3,724
)
January 12, 2045
 
(188,867
)
 
(2,581
)
 
1,162

 
(1,419
)
Total
 
$
(868,145
)
 
$
(7,120
)
 
$
(1,383
)
 
$
(8,503
)
(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 March 31, 2016 and December 31, 2015, 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 tables present credit default swaps through which the Company is receiving protection held as of March 31, 2016 and December 31, 2015:
(notional and dollars in thousands)
 
 
 
 
 
 
 
 
March 31, 2016
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
)
 
$
(249
)
 
$
(260
)
 
$
(509
)
 
 
December 20, 2016
 
496.00

 
(25,000
)
 
(141
)
 
(4,062
)
 
(4,203
)
 
 
Total
 
183.60

 
$
(125,000
)
 
$
(390
)
 
$
(4,322
)
 
$
(4,712
)

(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
)

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, 2016, the fair value of derivative financial instruments as an asset and liability position was $197.8 million and $77.0 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 March 31, 2016, the Company had received cash deposits from counterparties of $2.2 million and placed cash deposits of $232.1 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 condensed 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 condensed consolidated balance sheets as assets or liabilities and measured at fair value. Subsequent changes in fair value are recorded on the Company’s condensed 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 March 31, 2016 and December 31, 2015, the Company had outstanding commitments to purchase $252.2 million and $286.1 million of mortgage loans, subject to fallout if the loans do not close, with a fair value asset of $0.5 million and a fair value liability of $12,492 at March 31, 2016 and a fair value asset of $0.1 million and a fair value liability of $0.4 million at December 31, 2015, respectively.
Inverse Interest-Only Securities. As of March 31, 2016 and December 31, 2015, inverse interest-only securities with a carrying value of $158.8 million and $159.6 million, including accrued interest receivable of $1.6 million and $1.7 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, 2016 and December 31, 2015:
(in thousands)
March 31,
2016
 
December 31,
2015
Face Value
$
882,726

 
$
932,037

Unamortized premium
—

 
—

Unamortized discount
 
 
 
Designated credit reserve
—

 
—

Net, unamortized
(750,622
)
 
(792,178
)
Amortized Cost
132,104

 
139,859

Gross unrealized gains
25,538

 
19,655

Gross unrealized losses
(423
)
 
(1,608
)
Carrying Value
$
157,219

 
$
157,906