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

Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

3 Months Ended

Mar. 31, 2024

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities

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

To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio 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 TBAs, interest rate swap and swaption agreements, futures and options on futures. The Company has also entered into a number of non-derivative instruments to manage interest rate risk, principally MSR and interest-only securities (see discussion below).

The following summarizes the Company’s significant asset and liability classes, the risk exposure for these classes, and the Company’s risk management activities used to mitigate these risks. The discussion includes both derivative and non-derivative instruments used as part of these risk management activities. Any of the Company’s derivative and non-derivative instruments may be entered into in conjunction with one another in order to mitigate risks. As a result, the following discussions of each type of instrument should be read as a collective representation of the Company’s risk mitigation efforts and should not be considered independent of one another. While the Company uses derivative and non-derivative instruments to achieve the Company’s risk management activities, it is possible that these instruments will not effectively mitigate all or a substantial portion of the Company’s market rate risk. In addition, the Company might elect, at times, not to enter into certain hedging arrangements in order to maintain compliance with REIT requirements.

Balance Sheet Presentation

In accordance with ASC 815, the Company records derivative financial instruments on its condensed consolidated balance sheets as assets or liabilities at fair value. Changes in fair value are accounted for depending on the use of the derivative instruments and whether they are designated or 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 March 31, 2024 and December 31, 2023:


	March 31, 2024
	Derivative Assets				Derivative Liabilities
(in thousands)	Fair Value		Notional		Fair Value		Notional
Inverse interest-only securities	$	9,885	$	156,527	$	—	$	—
Interest rate swap agreements	—		9,822,112		—		—


Swaptions, net	—		—		—		—
TBAs	14,512		3,968,000		(3,027)		(518,000)


Futures, net	—		(5,638,800)		—		—


Total	$	24,397	$	8,307,839	$	(3,027)	$	(518,000)


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


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


Futures, net	—		—		—		(6,203,050)


Total	$	85,291	$	2,942,735	$	(21,506)	$	12,103,064

Comprehensive Income (Loss) Statement Presentation

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

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


Derivative Instruments	Location of Gain (Loss) Recognized in Income		Amount of Gain (Loss) Recognized in Income
		Three Months Ended
(in thousands)		March 31,
			2024		2023
Interest rate risk management:
TBAs	Gain (loss) on other derivative instruments		$	(59,180)	$	(17,164)

Futures	Gain (loss) on other derivative instruments		108,936		(140,087)


Options on futures	Gain (loss) on other derivative instruments		(127)		—
Interest rate swaps - Payers	Gain (loss) on interest rate swap and swaption agreements		194,430		(71,760)
Interest rate swaps - Receivers	Gain (loss) on interest rate swap and swaption agreements		(95,951)		(10,368)
Swaptions	Gain (loss) on interest rate swap and swaption agreements		31		(26)




Non-risk management:

Inverse interest-only securities	Gain (loss) on other derivative instruments		(2,030)		1,480

Total			$	146,109	$	(237,925)

For the three months ended March 31, 2024 and 2023, the Company recognized $14.3 million and $3.6 million of income, respectively, for the accrual and/or settlement of the net interest spread associated with its interest rate swaps. The income resulted from paying either a fixed interest rate or a floating interest rate (OIS or SOFR) and receiving either a floating interest rate (OIS or SOFR) or a fixed interest rate on an average $15.1 billion and $3.2 billion notional, respectively.

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, 2024 and 2023:


	Three Months Ended March 31, 2024
(in thousands)	Beginning of Period Notional Amount		Additions		Settlement, Termination, Expiration or Exercise		End of Period Notional Amount		Average Notional Amount		Realized Gain (Loss), net (1)
Inverse interest-only securities	$	163,735	$	—	$	(7,208)	$	156,527	$	160,491	$	—
Interest rate swap agreements	17,788,114		6,567,062		(14,533,064)		9,822,112		15,136,445		13,988


Swaptions, net	(200,000)		(500,000)		700,000		—		(232,967)		(98)
TBAs, net	3,497,000		12,173,000		(12,220,000)		3,450,000		3,037,747		(19,190)


Futures, net	(6,203,050)		(7,738,100)		8,302,350		(5,638,800)		(6,576,900)		(8,714)


Options on futures, net	—		—		—		—		—		(127)
Total	$	15,045,799	$	10,501,962	$	(17,757,922)	$	7,789,839	$	11,524,816	$	(14,141)


	Three Months Ended March 31, 2023
(in thousands)	Beginning of Period Notional Amount		Additions		Settlement, Termination, Expiration or Exercise		End of Period Notional Amount		Average Notional Amount		Realized Gain (Loss), net (1)
Inverse interest-only securities	$	196,456	$	—	$	(8,371)	$	188,085	$	192,729	$	—
Interest rate swap agreements	—		9,992,941		(1,588,069)		8,404,872		3,196,969		(18,580)


Swaptions, net	—		(200,000)		—		(200,000)		(57,778)		—
TBAs, net	3,826,000		14,666,000		(14,774,000)		3,718,000		4,073,467		(88,483)


Futures, net	(18,285,452)		(13,034,050)		24,373,952		(6,945,550)		(15,622,322)		131



Total	$	(14,262,996)	$	11,424,891	$	8,003,512	$	5,165,407	$	(8,216,935)	$	(106,932)

____________________

(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 (gain) loss on interest rate swaps and swaptions and unrealized (gains) losses 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 short sales (purchases) of derivative instruments, net; proceeds from sales and settlement (payments for termination and settlement) of derivative instruments, net; and decrease in due to counterparties, net line items within the investing activities section of the condensed consolidated statements of cash flows.

Interest Rate Sensitive Assets/Liabilities

The Company’s Agency RMBS portfolio is generally subject to change in value when interest rates or prepayment speeds decrease or increase, depending on the type of investment. Periods of rising interest rates with corresponding decreasing prepayment speeds generally result in a decline in the value of the Company’s fixed-rate Agency principal and interest (P&I) RMBS. The impact of this effect on the Company’s fixed-rate Agency P&I RMBS portfolio is partially mitigated by the presence of fixed-rate interest-only Agency RMBS, which generally increase in value when prepayment speeds decrease and MSR, which generally increase in value when prepayment speeds decrease and interest rates increase. As of March 31, 2024 and December 31, 2023, the Company had $40.6 million and $41.9 million, respectively, of interest-only securities, and $3.1 billion and $3.1 billion, respectively, of MSR. Interest-only securities are included in AFS securities, at fair value, in the condensed consolidated balance sheets.

The Company monitors its borrowings under repurchase agreements and revolving credit facilities, which are generally floating-rate debt, in relation to the rate profile of its portfolio. In connection with its risk management activities, the Company enters into a variety of derivative and non-derivative instruments to economically hedge interest rate risk or duration mismatch (or gap) by adjusting the duration of its floating-rate borrowings into fixed-rate borrowings to more closely match the duration of its assets. This particularly applies to borrowing agreements with maturities or interest rate resets of less than six months. Typically, the interest receivable terms (e.g., OIS or SOFR) of certain derivatives match the terms of the underlying debt, resulting in an effective conversion of the rate of the related borrowing agreement from floating to fixed. The objective is to manage the cash flows associated with current and anticipated interest payments on borrowings, as well as the ability to roll or refinance borrowings at the desired amount by adjusting the duration. To help manage the adverse impact of interest rate changes on the value of the Company’s portfolio 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, interest rate swap and swaption agreements, futures and options on futures.

TBAs. The Company may use TBAs as a means of deploying capital until targeted investments are available or to take advantage of temporary displacements, funding advantages or valuation differentials in the marketplace. Additionally, the Company may use TBAs independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. TBAs are forward contracts for the purchase (long notional positions) or sale (short notional positions) of Agency RMBS. The issuer, coupon and stated maturity of the Agency RMBS are predetermined as well as the trade price, face amount and future settle date (published each month by the Securities Industry and Financial Markets Association). However, the specific Agency RMBS to be delivered upon settlement is not known at the time of the TBA transaction. As a result, and because physical delivery of the Agency RMBS upon settlement cannot be assured, the Company accounts for TBAs as derivative instruments.

The Company may hold both long and short notional TBA positions, which are disclosed on a gross basis according to the unrealized gain or loss position of each TBA contract regardless of long or short notional position. The following tables present the notional amount, cost basis, market value and carrying value (which approximates fair value) of the Company’s TBA positions as of March 31, 2024 and December 31, 2023:


	March 31, 2024
							Net Carrying Value (4)
(in thousands)	Notional Amount (1)		Cost Basis (2)		Market Value (3)		Derivative Assets		Derivative Liabilities
Purchase contracts	$	4,193,000	$	4,129,470	$	4,143,411	$	14,512	$	(571)
Sale contracts	(743,000)		(707,538)		(709,994)		—		(2,456)
TBAs, net	$	3,450,000	$	3,421,932	$	3,433,417	$	14,512	$	(3,027)


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

___________________

(1)Notional amount represents the face amount of the underlying Agency RMBS.

(2)Cost basis represents the forward price to be paid (received) for the underlying Agency RMBS.

(3)Market value represents the current market value of the TBA (or of the underlying Agency RMBS) as of period end.

(4)Net carrying value represents the difference between the market value of the TBA as of period end and its cost basis, and is reported in derivative assets / (liabilities), at fair value, in the condensed consolidated balance sheets.

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


(dollars in thousands)	March 31, 2024					December 31, 2023
Type & Maturity	Notional Amount		Carrying Value		Weighted Average Months to Expiration	Notional Amount		Carrying Value		Weighted Average Months to Expiration
U.S. Treasury futures - 2 year	$	(497,400)	$	—	2.93	$	(549,600)	$	—	2.89
U.S. Treasury futures - 5 year	(1,354,200)		—		2.93	(1,876,700)		—		2.89
U.S. Treasury futures - 10 year	(1,925,500)		—		2.60	(983,300)		—		2.60
U.S. Treasury futures - 20 year	(40,700)		—		2.60	(388,200)		—		2.89
Eris SOFR swap futures - 10 year	(30,000)		—		122.73	—		—		—
SOFR futures
≤ 1 year	(1,416,000)		—		5.68	(1,842,750)		—		6.05
> 1 and ≤ 2 years	(375,000)		—		16.06	(562,500)		—		17.56

Total futures	$	(5,638,800)	$	—	5.01	$	(6,203,050)	$	—	5.10

Interest Rate Swap Agreements. The Company may use interest rate swaps independently, or in conjunction with other derivative and non-derivative instruments, in order to mitigate risks. As of March 31, 2024 and December 31, 2023, the Company held the following interest rate swaps that were utilized as economic hedges of interest rate exposure (or duration) whereby the Company receives interest at a floating interest rate (OIS or SOFR):


(notional in thousands)
March 31, 2024
Swaps Maturities	Notional Amount (1)		Weighted Average Fixed Pay Rate (2)		Weighted Average Receive Rate		Weighted Average Maturity (Years)
≤ 1 year	$	2,647,671	4.730	%	5.340	%	0.96
> 1 and ≤ 3 years	1,968,891		4.087	%	5.340	%	1.76
> 3 and ≤ 5 years	1,784,642		3.546	%	5.340	%	3.78
> 5 and ≤ 7 years	—		—	%	—	%	0.00
> 7 and ≤ 10 years	1,005,904		3.577	%	5.340	%	9.00
> 10 years	466,637		3.753	%	5.340	%	14.32
Total	$	7,873,745	4.180	%	5.340	%	3.38


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

____________________

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

(2)Weighted averages exclude forward starting interest rate swaps. As of March 31, 2024 and December 31, 2023, the weighted average fixed pay rate on forward starting interest rate swaps was 4.0% and 4.0%, respectively.

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


(notional in thousands)
March 31, 2024
Swaps Maturities	Notional Amount (1)		Weighted Average Pay Rate (2)		Weighted Average Fixed Receive Rate (2)		Weighted Average Maturity (Years) (2)
≤ 1 year	$	786,641	5.340	%	4.025	%	0.97
> 1 and ≤ 3 years	641,100		—	%	—	%	0.00
> 3 and ≤ 5 years	260,000		5.340	%	3.328	%	3.50
> 5 and ≤ 7 years	—		—	%	—	%	0.00
> 7 and ≤ 10 years	—		—	%	—	%	0.00
> 10 years	260,626		5.340	%	3.444	%	19.76
Total	$	1,948,367	5.340	%	3.770	%	5.22


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

____________________

(1)Notional amount includes $641.1 million and $645.2 million in forward starting interest rate swaps as of March 31, 2024 and December 31, 2023, respectively.

(2)Weighted averages exclude forward starting interest rate swaps. As of March 31, 2024 and December 31, 2023, the weighted average fixed receive rate on forward starting interest rate swaps was 4.3% and 4.4%, respectively.

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


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







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

Credit Risk

The Company’s exposure to credit losses on its Agency RMBS portfolio is limited due to implicit or explicit backing from either a GSE or a U.S. government agency. The payment of principal and interest on the Freddie Mac and Fannie Mae mortgage-backed securities are guaranteed by those respective agencies, and the payment of principal and interest on the Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. government.

In future periods, the Company could enhance its credit risk protection, enter into further paired derivative positions, including both long and short credit default swaps, and/or seek opportunistic trades in the event of a market disruption (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 March 31, 2024, the fair value of derivative financial instruments as an asset and liability position was $24.4 million and $3.0 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 internal credit guidelines. The Company also seeks to spread its credit risk exposure across multiple counterparties in order to reduce its exposure to any single counterparty. Additionally, the Company reduces credit risk on the majority of its derivative instruments by entering into agreements that permit the closeout and netting of transactions with the same counterparty or clearing agency upon the occurrence of certain events. To further mitigate the risk of counterparty default, the Company maintains collateral agreements with certain of its counterparties and clearing agencies, which require both parties to maintain cash deposits in the event the fair values of the derivative financial instruments exceed established thresholds. The Company’s centrally cleared interest rate swaps and exchange-traded futures and options on futures require the Company to post an “initial margin” amount determined by the clearing exchange, which is generally intended to be set at a level sufficient to protect the exchange from the derivative instrument’s maximum estimated single-day price movement. The Company also exchanges “variation margin” based upon daily changes in fair value, as measured by the exchange. The exchange of variation margin is considered a settlement of the derivative instrument, as opposed to pledged collateral. Accordingly, the Company accounts for the receipt or payment of variation margin as a direct reduction to the carrying value of the centrally cleared or exchange-traded derivative asset or liability.