Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities

v3.20.2
Derivative Instruments and Hedging Activities
 9 Months Ended
Sep. 30, 2020
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 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., LIBOR or the OIS rate) 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 as well as its cash flows, the Company may, at times, enter into various forward contracts, including short securities, Agency to-be-announced securities, or TBAs, options, futures, swaps, caps and total return swaps. In executing on the Company’s current risk management strategy, the Company has entered into interest rate swap agreements and TBAs. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally MSR and Agency 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, Derivatives and Hedging, 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 qualifying 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, 2020 and December 31, 2019.
September 30, 2020
Derivative Assets Derivative Liabilities
(in thousands) Fair Value Notional Fair Value Notional
Inverse interest-only securities
 $ 67,468  $ 338,646  $ —  $ — 
Interest rate swap agreements
 —  —  —  12,394,818 
Swaptions, net 10,791  6,000,000  —  — 
TBAs 18,460  3,947,000  (3,551) 2,289,000 
U.S. Treasury futures 1,170  866,600  —  — 
Total $ 97,889  $ 11,152,246  $ (3,551) $ 14,683,818 
December 31, 2019
Derivative Assets Derivative Liabilities
(in thousands) Fair Value Notional Fair Value Notional
Inverse interest-only securities
 $ 69,469  $ 397,137  $ —  $ — 
Interest rate swap agreements
 102,268  2,725,000  —  36,977,470 
Swaptions, net 7,801  1,257,000  —  — 
TBAs 8,011  9,584,000  (6,711) (2,157,000)
U.S. Treasury futures 502  380,000  —  — 
Markit IOS total return swaps
 —  —  (29) 41,890 
Total $ 188,051  $ 14,343,137  $ (6,740) $ 34,862,360 

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,
2020 2019 2020 2019
Interest rate risk management
TBAs
Gain on other derivative instruments
 $ 60,993  $ 82,964  $ (29,385) $ 221,439 
Short U.S. Treasuries
Gain on other derivative instruments
 —  —  —  (6,801)
U.S. Treasury futures
Gain on other derivative instruments
 4,448  (359) 26,956  46,089 
Put and call options for TBAs
Gain on other derivative instruments
 —  —  —  (7,666)
Interest rate swaps - Payers
Gain (loss) on interest rate swap, cap and swaption agreements
 8,269  (172,856) (1,151,119) (834,426)
Interest rate swaps - Receivers
Gain (loss) on interest rate swap, cap and swaption agreements
 (7,879) 211,086  904,492  664,313 
Swaptions
Gain (loss) on interest rate swap, cap and swaption agreements
 1,011  32,390  (49,490) 76,383 
Interest rate caps
Gain (loss) on interest rate swap, cap and swaption agreements
 —  —  —  (7,684)
Markit IOS total return swaps
Gain on other derivative instruments
 —  (888) (2,430) (1,365)
Non-risk management
Inverse interest-only securities
Gain on other derivative instruments
 155  4,139  13,593  19,102 
Total $ 66,997  $ 156,476  $ (287,383) $ 169,384 

For the three and nine months ended September 30, 2020, the Company recognized $0.8 million of income and $68.1 million of expense, respectively, for the accrual and/or settlement of the net interest expense associated with its interest rate swaps and caps. The income results from receiving either a floating interest rate (LIBOR or the OIS rate) or a fixed interest rate and paying either a fixed interest rate or a floating interest rate (LIBOR or the OIS rate) on an average $7.6 billion and $32.0 billion notional, respectively. For the three and nine months ended September 30, 2019, the Company recognized $19.2 million and $65.7 million, respectively, of income for the accrual and/or settlement of the net interest expense associated with its interest rate swaps and caps. The income results from paying either a fixed interest rate or a floating interest rate (LIBOR or the OIS rate) and receiving either a floating interest rate (LIBOR or the OIS rate) or a fixed interest rate on an average $41.2 billion and $39.8 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, 2020 and 2019:
Three Months Ended September 30, 2020
(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 $ 361,933  $ —  $ (23,287) $ 338,646  $ 350,876  $ — 
Interest rate swap agreements 4,479,000  7,915,818  —  12,394,818  7,595,385  — 
Swaptions, net —  6,000,000  —  6,000,000  239,130  — 
TBAs, net 3,236,000  21,358,000  (18,358,000) 6,236,000  4,760,456  82,490 
U.S. Treasury futures —  2,552,500  (1,685,900) 866,600  986,795  3,291 
Total $ 8,076,933  $ 37,826,318  $ (20,067,187) $ 25,836,064  $ 13,932,642  $ 85,781 
Three Months Ended September 30, 2019
(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 $ 436,611  $ —  $ (20,668) $ 415,943  $ 427,222  $ — 
Interest rate swap agreements 40,470,277  17,874,435  (16,511,217) 41,833,495  41,180,308  38,044 
Interest rate cap contracts —  —  —  —  —  — 
Swaptions, net 3,875,000  1,000,000  (3,125,000) 1,750,000  2,650,815  37,365 
TBAs, net 9,422,000  40,347,000  (39,906,000) 9,863,000  9,107,707  94,505 
U.S. Treasury futures 1,300,000  3,567,000  (4,547,000) 320,000  657,022  26,939 
Markit IOS total return swaps 45,536  —  (1,769) 43,767  46,088  — 
Total $ 55,549,424  $ 62,788,435  $ (64,111,654) $ 54,226,205  $ 54,069,162  $ 196,853 
Nine Months Ended September 30, 2020
(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 $ 397,137  $ —  $ (58,491) $ 338,646  $ 370,379  $ — 
Interest rate swap agreements 39,702,470  56,403,253  (83,710,905) 12,394,818  32,006,660  (334,502)
Swaptions, net 1,257,000  7,017,000  (2,274,000) 6,000,000  956,387  (50,700)
TBAs, net 7,427,000  41,431,000  (42,622,000) 6,236,000  3,809,515  (42,993)
U.S. Treasury futures (380,000) 10,782,500  (9,535,900) 866,600  681,497  26,295 
Markit IOS total return swaps 41,890  —  (41,890) —  13,547  (2,077)
Total $ 48,445,497  $ 115,633,753  $ (138,243,186) $ 25,836,064  $ 37,837,985  $ (403,977)
Nine Months Ended September 30, 2019
(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 $ 476,299  $ —  $ (60,356) $ 415,943  $ 447,082  $ — 
Interest rate swap agreements 29,523,605  32,373,068  (20,063,178) 41,833,495  38,402,820  41,975 
Interest rate cap contracts 2,500,000  —  (2,500,000) —  1,417,216  (8,690)
Swaptions, net 63,000  14,200,000  (12,513,000) 1,750,000  3,259,802  63,139 
TBAs, net 6,484,000  119,252,000  (115,873,000) 9,863,000  8,905,264  242,102 
Short U.S. Treasuries (800,000) —  800,000  —  (61,097) (23,172)
U.S. Treasury futures —  8,077,000  (7,757,000) 320,000  691,414  47,565 
Put and call options for TBAs, net (1,767,000) —  1,767,000  —  (147,606) (32,962)
Markit IOS total return swaps 48,265  —  (4,498) 43,767  45,964  — 
Total $ 36,528,169  $ 173,902,068  $ (156,204,032) $ 54,226,205  $ 52,960,859  $ 329,957 
____________________
(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 on interest rate swaps, caps and swaptions and unrealized gain on other derivative instruments 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 (purchases) short sales of other derivative instruments, (payments for termination and settlement) proceeds from sales and settlements of derivative instruments, net and increase (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 mortgage rates decline or increase, depending on the type of investment. Rising mortgage rates generally result in a decline in the value of the Company’s fixed-rate Agency principal and interest (P&I) RMBS. To mitigate the impact of this risk on the Company’s fixed-rate Agency P&I RMBS portfolio, the Company maintains a portfolio of fixed-rate interest-only securities and MSR, which increase in value when interest rates increase. As of September 30, 2020 and December 31, 2019, the Company had $48.7 million and $122.2 million, respectively, of interest-only securities, and $1.3 billion and $1.9 billion, respectively, of MSR in place to primarily hedge its Agency RMBS. 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, FHLB advances 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., LIBOR or the OIS rate) 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 as well as its cash flows, the Company may, at times, enter into various forward contracts, including short securities, TBAs, options, futures, swaps, caps, credit default swaps and total return swaps. In executing on the Company’s current interest rate risk management strategy, the Company has entered into TBAs and interest rate swap agreements.
TBAs. At times, 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, 2020 and December 31, 2019:
September 30, 2020
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
Cost Basis (2)
Market Value (3)
Derivative Assets Derivative Liabilities
Purchase contracts $ 8,789,000  $ 9,196,682  $ 9,210,143  $ 16,768  $ (3,307)
Sale contracts (2,553,000) (2,700,653) (2,699,205) 1,692  (244)
TBAs, net $ 6,236,000  $ 6,496,029  $ 6,510,938  $ 18,460  $ (3,551)
December 31, 2019
Net Carrying Value (4)
(in thousands)
Notional Amount (1)
Cost Basis (2)
Market Value (3)
Derivative Assets Derivative Liabilities
Purchase contracts $ 10,223,000  $ 10,557,745  $ 10,565,556  $ 8,011  $ (200)
Sale contracts (2,796,000) (2,902,858) (2,909,369) —  (6,511)
TBAs, net $ 7,427,000  $ 7,654,887  $ 7,656,187  $ 8,011  $ (6,711)
___________________
(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.

U.S. Treasury Futures. The Company may use U.S. Treasury futures independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of September 30, 2020 and December 31, 2019, the Company had purchased U.S. Treasury futures with a notional amount of $866.6 million and $380.0 million and a fair market value of $1.2 million and $0.5 million included in derivative assets, at fair value, on the condensed consolidated balance sheet as of September 30, 2020 and December 31, 2019, respectively.
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, 2020 and December 31, 2019, 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 (LIBOR or the OIS rate):
(notional in thousands)
September 30, 2020
Swaps Maturities Notional Amount Weighted Average Fixed Pay Rate Weighted Average Receive Rate Weighted Average Maturity (Years)
2022 $ 7,415,818  0.042  % 0.090  % 1.91
2023 2,281,500  0.023  % 0.090  % 2.73
2024 and Thereafter 1,497,500  0.257  % 0.090  % 6.74
Total $ 11,194,818  0.067  % 0.090  % 2.72
(notional in thousands)
December 31, 2019
Swaps Maturities Notional Amount Weighted Average Fixed Pay Rate Weighted Average Receive Rate Weighted Average Maturity (Years)
2020 $ 3,640,000  1.806  % 1.937  % 0.83
2021 15,740,977  1.681  % 1.910  % 1.47
2022 2,578,640  1.911  % 1.901  % 2.74
2023 215,000  3.057  % 1.910  % 3.90
2024 and Thereafter 8,739,092  2.224  % 1.935  % 7.20
Total $ 30,913,709  1.878  % 1.921  % 3.14

Additionally, as of September 30, 2020 and December 31, 2019, the Company held the following interest rate swaps in order to mitigate mortgage interest rate exposure (or duration) risk whereby the Company pays interest at a floating interest rate (LIBOR or the OIS rate):
(notional in thousands)
September 30, 2020
Swaps Maturities Notional Amounts Weighted Average Pay Rate Weighted Average Fixed Receive Rate Weighted Average Maturity (Years)
2024 and Thereafter $ 1,200,000  0.090  % 0.442  % 9.68
Total $ 1,200,000  0.090  % 0.442  % 9.68
(notional in thousands)
December 31, 2019
Swaps Maturities Notional Amounts Weighted Average Pay Rate Weighted Average Fixed Receive Rate Weighted Average Maturity (Years)
2020 $ 250,000  1.953  % 2.258  % 0.06
2021 915,000  1.894  % 2.516  % 1.10
2022 —  —  % —  % 0.00
2023 —  —  % —  % 0.00
2024 and Thereafter 7,623,761  1.937  % 2.232  % 8.64
Total $ 8,788,761  1.933  % 2.262  % 7.61
Interest Rate Swaptions. The Company may use interest rate swaptions (agreements to enter into interest rate swaps in the future for which the Company would either pay or receive a fixed rate) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of September 30, 2020 and December 31, 2019, the Company had the following outstanding interest rate swaptions that were utilized as macro-economic hedges:
September 30, 2020
(notional and dollars in thousands) Option Underlying Swap
Swaption Expiration Cost Basis Fair Value Average Months to Expiration Notional Amount Average Pay Rate Average Receive Rate Average Term (Years)
Purchase contracts:
Payer < 6 Months $ 5,780  $ 6,942  3.36  $ 3,000,000  1.23  % SOFR 10.0
Receiver < 6 Months $ 4,000  $ 3,849  3.36  $ 3,000,000  SOFR 0.23  % 10.0
December 31, 2019
(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 $ 24,700  $ 16,095  3.20  $ 7,525,000  2.27  % 3M Libor 10.0
Receiver < 6 Months $ 4,100  $ 342  1.10  $ 500,000  3M Libor 1.55  % 10.0
Sale contracts:
Receiver < 6 Months $ (20,800) $ (8,636) 3.24  $ (6,768,000) 3M Libor 1.28  % 10.0

Markit IOS Total Return Swaps. The Company may use total return swaps (agreements whereby the Company receives or makes payments based on the total return of an underlying instrument or index, such as the Markit IOS Index, in exchange for fixed or floating rate interest payments) independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. The Company enters into total return swaps to help mitigate the potential impact of larger increases or decreases in interest rates on the performance of our 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 did not hold any total return swaps as of September 30, 2020. As of December 31, 2019, the Company had the following total return swap agreements in place:
(notional and dollars in thousands)
December 31, 2019
Maturity Date Current Notional Amount Fair Value Cost Basis Unrealized Gain (Loss)
January 12, 2043 $ (18,625) $ 5  $ (30) $ 35 
January 12, 2044 (23,265) (34) (29) (5)
Total $ (41,890) $ (29) $ (59) $ 30 

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.
For non-Agency securities, 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 securities.
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, 2020, the fair value of derivative financial instruments as an asset and liability position was $97.9 million and $3.6 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, 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. The Company’s centrally cleared interest rate swaps require that the Company posts 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 interest rate swap’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 interest rate swap, 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 interest rate swap asset or liability.