10. DERIVATIVE INSTRUMENTS

Derivative instruments include, but are not limited to, interest rate swaps, options to enter into interest rate swaps (“swaptions”), TBA derivatives, options on TBA securities (“MBS options”), U.S. Treasury and Eurodollar futures contracts and certain forward purchase commitments. The Company may also enter into other types of mortgage derivatives such as interest-only securities, credit derivatives referencing the commercial mortgage-backed securities index and synthetic total return swaps.

In connection with the Company’s investment/market rate risk management strategy, the Company economically hedges a portion of its interest rate risk by entering into derivative financial instrument contracts, which include interest rate swaps, swaptions and futures contracts. The Company may also enter into TBA derivatives, MBS options and U.S. Treasury or Eurodollar futures contracts, certain forward purchase commitments and credit derivatives to economically hedge its exposure to market risks. The purpose of using derivatives is to manage overall portfolio risk with the potential to generate additional income for distribution to stockholders. These derivatives are subject to changes in market values resulting from changes in interest rates, volatility, Agency mortgage-backed security spreads to U.S. Treasuries and market liquidity. The use of derivatives also creates exposure to credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their obligations under the stated contract. Additionally, the Company may have to pledge cash or assets as collateral for the derivative transactions, the amount of which may vary based on the market value and terms of the derivative contract. In the case of market agreed coupon (“MAC”) interest rate swaps, the Company may make or receive a payment at the time of entering into such interest rate swap to compensate for the out of market nature of such interest rate swap. Similar to other interest rate swaps, the Company may have to pledge cash or assets as collateral for the MAC interest rate swap transactions. In the event of a default by the counterparty, the Company could have difficulty obtaining its pledged collateral as well as receiving payments in accordance with the terms of the derivative contracts.

Derivatives are accounted for in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging, which requires recognition of all derivatives as either assets or liabilities at fair value in the Consolidated Statements of Financial Condition with changes in fair value recognized in the Consolidated Statements of Comprehensive Income (Loss). The changes in the estimated fair value are presented within Net gains (losses) on other derivatives with the exception of interest rate swaps which are separately presented. None of the Company’s derivative transactions have been designated as hedging instruments for accounting purposes.

The Company also maintains collateral in the form of cash on margin with counterparties to its interest rate swaps and other derivatives. In accordance with a clearing organization’s rulebook, the Company presents the fair value of centrally cleared interest rate swaps net of variation margin pledged under such transactions. At December 31, 2018, $496.2 million of variation margin was reported as a reduction to interest rate swaps, at fair value.

Interest Rate Swap Agreements – Interest rate swap agreements are the primary instruments used to mitigate interest rate risk. In particular, the Company uses interest rate swap agreements to manage its exposure to changing interest rates on its repurchase agreements by economically hedging cash flows associated with these borrowings. Interest rate swap agreements may or may not be cleared through a derivatives clearing organization (“DCO”). Uncleared interest rate swaps are fair valued using internal pricing models and compared to the counterparty market values. Centrally cleared interest rate swaps are generally fair valued using the DCO’s market values. MAC interest rate swaps are also centrally cleared and fair valued using internal pricing models and compared to the DCO’s market value.

Swaptions – Swaptions are purchased or sold to mitigate the potential impact of increases or decreases in interest rates. Interest rate swaptions provide the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. They are not centrally cleared. The premium paid or received for swaptions is reported as an asset or liability in the Consolidated Statements of Financial Condition. If a swaption expires unexercised, the realized gain (loss) on the swaption would be equal to the premium received or paid. If the Company sells or exercises a swaption, the realized gain or loss on the swaption would be equal to the difference between the cash received or the fair value of the underlying interest rate swap received and the premium paid.

The fair value of swaptions is estimated using internal pricing models and compared to the counterparty market value.

TBA Dollar Rolls – TBA dollar roll transactions are accounted for as a series of derivative transactions. The fair value of TBA derivatives is based on methods similar to those used to value Agency mortgage-backed securities.

MBS Options – MBS options are generally options on TBA contracts, which help manage mortgage market risks and volatility while providing the potential to enhance returns. MBS options are over-the-counter traded instruments and those written on current-coupon mortgage-backed securities are typically the most liquid. MBS options are measured at fair value using internal pricing models and compared to the counterparty market value at the valuation date.

Futures Contracts – Futures contracts are derivatives that track the prices of specific assets or benchmark rates. Short sales of futures contracts help to mitigate the potential impact of changes in interest rates on the portfolio performance. The Company maintains margin accounts which are settled daily with Futures Commission Merchants (“FCMs”). The margin requirement varies based on the market value of the open positions and the equity retained in the account. Futures contracts are fair valued based on exchange pricing.

Forward Purchase Commitments – The Company may enter into forward purchase commitments with counterparties whereby the Company commits to purchasing residential mortgage loans at a particular price, provided the residential mortgage loans close with the counterparties. The counterparties are required to deliver the committed loans on a “best efforts” basis.

Credit Derivatives – The Company may enter into credit derivatives referencing the commercial mortgage-backed securities index, such as the CMBX index, and synthetic total return swaps. Refer to the section titled “Glossary of Terms” located in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information related to the CMBX index.

The table below summarizes fair value information about our derivative assets and liabilities at December 31, 2018 and 2017:



Derivatives Instruments	December 31, 2018		December 31, 2017
Assets	(dollars in thousands)
Interest rate swaps	$	48,114	$	30,272
Interest rate swaptions	7,216		36,150
TBA derivatives	141,688		29,067
Futures contracts	—		218,361
Purchase commitments	844		35
Credit derivatives⁽¹⁾	2,641		—
	$	200,503	$	313,885
Liabilities
Interest rate swaps	$	420,365	$	569,129
TBA derivatives	—		21,776
Futures contracts	462,309		12,285
Purchase commitments	33		157
Credit derivatives ⁽¹⁾	7,043		4,507
	$	889,750	$	607,854

⁽¹⁾

The notional amount of the credit derivatives in which the Company purchased protection was $30.0 million at December 31, 2018. The maximum potential amount of future payments is the notional amount of credit derivatives in which the Company sold protection of $451.0 million and $125.0 million at December 31, 2018 and December 31, 2017, respectively, plus any coupon shortfalls on the underlying tranche. The credit derivative tranches referencing the basket of bonds had a range of ratings between AAA and BBB-.

The following table summarizes certain characteristics of the Company’s interest rate swaps at December 31, 2018 and 2017:



December 31, 2018
Maturity	Current Notional ⁽¹⁾		Weighted Average Pay Rate		Weighted Average Receive Rate		Weighted Average Years to Maturity
(dollars in thousands)
0 - 3 years	$	31,900,200	1.84	%	2.73	%	1.21
3 - 6 years	16,603,200		2.29	%	2.70	%	4.30
6 - 10 years	18,060,900		2.57	%	2.56	%	8.62
Greater than 10 years	3,901,400		3.63	%	2.59	%	17.33
Total / Weighted average	$	70,465,700	2.17	%	2.68	%	4.26

December 31, 2017
Maturity	Current Notional ⁽¹⁾		Weighted Average Pay Rate ^{(2) (3)}		Weighted Average Receive Rate ⁽²⁾		Weighted Average Years to Maturity ⁽²⁾
(dollars in thousands)
0 - 3 years	$	6,532,000	1.56	%	1.62	%	2.08
3 - 6 years	14,791,800		2.12	%	1.57	%	4.51
6 - 10 years	10,179,000		2.35	%	1.58	%	8.04
Greater than 10 years	3,826,400		3.65	%	1.51	%	18.47
Total / Weighted average	$	35,329,200	2.22	%	1.58	%	6.72


⁽¹⁾	There were no forward starting swaps at December 31, 2018. Notional amount includes $8.1 billion forward starting pay fixed swaps at December 31, 2017.


⁽²⁾	Excludes forward starting swaps.


⁽³⁾	Weighted average fixed rate on forward starting pay fixed swaps was 1.86% at December 31, 2017.

The following table presents swaptions outstanding at December 31, 2018 and 2017.



December 31, 2018
	Current Underlying Notional	Weighted Average Underlying Pay Rate	Weighted Average Underlying Receive Rate	Weighted Average Underlying Years to Maturity	Weighted Average Months to Expiration
(dollars in thousands)
Long	$4,075,000	3.30%	3M LIBOR	10.08	3.06

December 31, 2017
	Current Underlying Notional	Weighted Average Underlying Pay Rate	Weighted Average Underlying Receive Rate	Weighted Average Underlying Years to Maturity	Weighted Average Months to Expiration
(dollars in thousands)
Long	$6,000,000	2.62%	3M LIBOR	9.97	4.49

The following table summarizes certain characteristics of the Company’s TBA derivatives at December 31, 2018 and 2017:



December 31, 2018
Purchase and sale contracts for derivative TBAs	Notional			Implied Cost Basis			Implied Market Value			Net Carrying Value
(dollars in thousands)
Purchase contracts	$	13,803,000		$	13,823,109		$	13,964,797		$	141,688

December 31, 2017
Purchase and sale contracts for derivative TBAs	Notional			Implied Cost Basis			Implied Market Value			Net Carrying Value
(dollars in thousands)
Purchase contracts	$	15,828,000		$	16,381,826		$	16,390,251		8,425
Sale contracts	(250,000		)	(254,804		)	(255,938		)	(1,134		)
Net TBA derivatives	$	15,578,000		$	16,127,022		$	16,134,313		$	7,291

The following table summarizes certain characteristics of the Company’s futures derivatives at December 31, 2018 and 2017:



December 31, 2018
	Notional - Long Positions		Notional - Short Positions			Weighted Average Years to Maturity
	(dollars in thousands)
U.S. Treasury futures - 2 year	$	—	$	(1,166,000	)	1.97
U.S. Treasury futures - 5 year	—		(6,359,400		)	4.39
U.S. Treasury futures - 10 year and greater	—		(11,152,600		)	7.10
Total	$	—	$	(18,678,000	)	5.86

December 31, 2017
	Notional - Long Positions		Notional - Short Positions			Weighted Average Years to Maturity
	(dollars in thousands)
2-year swap equivalent Eurodollar contracts	$	—	$	(17,161,000	)	2.00
U.S. Treasury futures - 5 year	—		(4,217,400		)	4.41
U.S. Treasury futures - 10 year and greater	—		(4,914,500		)	7.01
Total	$	—	$	(26,292,900	)	3.32

The Company presents derivative contracts on a gross basis on the Consolidated Statements of Financial Condition. Derivative contracts may contain legally enforceable provisions that allow for netting or setting off receivables and payables with each counterparty.

The following tables present information about derivative assets and liabilities that are subject to such provisions and can potentially be offset on our Consolidated Statements of Financial Condition at December 31, 2018 and 2017, respectively.



December 31, 2018
			Amounts Eligible for Offset
	Gross Amounts		Financial Instruments			Cash Collateral			Net Amounts
Assets	(dollars in thousands)
Interest rate swaps, at fair value	$	48,114	$	(29,308	)	$	—		$	18,806
Interest rate swaptions, at fair value	7,216		—			—			7,216
TBA derivatives, at fair value	141,688		—			—			141,688
Purchase commitments	844		—			—			844
Credit derivatives	2,641		(2,641		)	—			—
Liabilities
Interest rate swaps, at fair value	$	420,365	$	(29,308	)	$	(11,856	)	$	379,201
Futures contracts, at fair value	462,309		—			(462,309		)	—
Purchase commitments	33		—			—			33
Credit derivatives	7,043		(2,641		)	(4,402		)	—

December 31, 2017
			Amounts Eligible for Offset
	Gross Amounts		Financial Instruments			Cash Collateral			Net Amounts
Assets	(dollars in thousands)
Interest rate swaps, at fair value	$	30,272	$	(27,379	)	$	—		$	2,893
Interest rate swaptions, at fair value	36,150		—			—			36,150
TBA derivatives, at fair value	29,067		(12,551		)	—			16,516
Futures contracts, at fair value	218,361		(12,285		)	—			206,076
Purchase commitments	35		—			—			35
Liabilities
Interest rate swaps, at fair value	$	569,129	$	(27,379	)	$	—		$	541,750
TBA derivatives, at fair value	21,776		(12,551		)	—			9,225
Futures contracts, at fair value	12,285		(12,285		)	—			—
Purchase commitments	157		—			—			157
Credit derivatives	4,507		—			(3,520		)	987

The effect of interest rate swaps on the Consolidated Statements of Comprehensive Income (Loss) is as follows:



Location on Consolidated Statements of Comprehensive Income (Loss)
	Realized Gains (Losses) on Interest Rate Swaps			Realized Gains (Losses) on Termination of Interest Rate Swaps			Unrealized Gains (Losses) on Interest Rate Swaps
For the years ended	(dollars in thousands)
December 31, 2018	$	100,553		$	1,409		$	424,081
December 31, 2017	$	(371,108	)	$	(160,133	)	$	512,918
December 31, 2016	$	(506,681	)	$	(113,941	)	$	282,190

The effect of other derivative contracts on the Company’s Consolidated Statements of Comprehensive Income (Loss) is as follows:



Year Ended December 31, 2018
Derivative Instruments	Realized Gain (Loss)			Unrealized Gain (Loss)			Amount of Gain/(Loss) Recognized in Net Gains (Losses) on Other Derivatives
(dollars in thousands)
Net TBA derivatives	$	(343,594	)	$	134,397		$	(209,197	)
Net interest rate swaptions	(98,248		)	2,679			(95,569		)
Futures	564,418			(668,384		)	(103,966		)
Purchase commitments	—			1,002			1,002
Credit derivatives	9,662			(5,945		)	3,717
Total							$	(404,013	)



Year Ended December 31, 2017
Derivative Instruments	Realized Gain (Loss)			Unrealized Gain (Loss)			Amount of Gain/(Loss) Recognized in Net Gains (Losses) on Other Derivatives
(dollars in thousands)
Net TBA derivatives	$	154,575		$	65,490		$	220,065
Net interest rate swaptions	(935		)	(42,660		)	(43,595		)
Futures	20,459			62,778			83,237
Purchase commitments	—			162			162
Credit derivatives	1,521			28			1,549
Total							$	261,418

Certain of the Company’s derivative contracts are subject to International Swaps and Derivatives Association Master Agreements or other similar agreements which may contain provisions that grant counterparties certain rights with respect to the applicable agreement upon the occurrence of certain events such as (i) a decline in stockholders’ equity in excess of specified thresholds or dollar amounts over set periods of time, (ii) the Company’s failure to maintain its REIT status, (iii) the Company’s failure to comply with limits on the amount of leverage, and (iv) the Company’s stock being delisted from the New York Stock Exchange.

Upon the occurrence of any one of items (i) through (iv), or another default under the agreement, the counterparty to the applicable agreement has a right to terminate the agreement in accordance with its provisions. The aggregate fair value of all derivative instruments with the aforementioned features are in a net asset position at December 31, 2018.