Derivative Instruments

The Company’s derivative instruments are primarily comprised of Swaps, the majority of which are designated as cash flow hedges against the interest rate risk associated with its borrowings. The Company has also entered into Linked Transactions, which are not designated as hedging instruments. The following table presents the fair value of the Company’s derivative instruments and their balance sheet location at June 30, 2014 and December 31, 2013:



			June 30, 2014		June 30, 2014			December 31, 2013
Derivative Instrument	Designation	Balance Sheet Location	Notional Amount		Fair Value
(In Thousands)
Linked Transactions	Non-Hedging	Assets	N/A		$	106,859		$	28,181
Non-cleared legacy Swaps (1)	Hedging	Assets	$	450,000	$	2,755		$	4,925
Cleared Swaps (2)	Hedging	Assets	$	—	$	—		$	8,075
Non-cleared legacy Swaps (1)	Hedging	Liabilities	$	927,214	$	(12,856	)	$	(24,437	)
Cleared Swaps (2)	Hedging	Liabilities	$	2,550,000	$	(44,570	)	$	(3,780	)

(1) Non-cleared legacy Swaps include Swaps executed and settled bilaterally with counterparties without the use of an organized exchange or central clearing house.

(2) Cleared Swaps include Swaps executed bilaterally with a counterparty in the over-the-counter market but then novated to a central clearing house, whereby the central clearing house becomes the counterparty to both of the original counterparties.

Linked Transactions

The Company’s Linked Transactions are evaluated on a combined basis, reported as forward (derivative) instruments and presented as assets on the Company’s consolidated balance sheets at fair value. The fair value of Linked Transactions reflect the value of the underlying Non-Agency MBS, linked repurchase agreement borrowings and accrued interest receivable/payable on such instruments. The Company’s Linked Transactions are not designated as hedging instruments and, as a result, the change in the fair value and net interest income from Linked Transactions is reported in other income on the Company’s consolidated statements of operations.

The following tables present certain information about the Non-Agency MBS and repurchase agreements underlying the Company’s Linked Transactions at June 30, 2014 and December 31, 2013:

Linked Transactions at June 30, 2014



Linked Repurchase Agreements					Linked MBS
	Balance		Weighted Average Interest Rate		Non-Agency MBS	Fair Value		Amortized Cost		Par/Current Face		Weighted Average Coupon Rate

Maturity or Repricing
(Dollars in Thousands)					(Dollars in Thousands)
Within 30 days	$	183,790	1.76	%	Total	$	494,047	$	486,220	$	499,034	3.55	%
>30 days to 90 days	203,739		1.54
Total	$	387,529	1.64	%

Linked Transactions at December 31, 2013



Linked Repurchase Agreements					Linked MBS
	Balance		Weighted Average Interest Rate		Non-Agency MBS	Fair Value		Amortized Cost		Par/Current Face		Weighted Average Coupon Rate

Maturity or Repricing
(Dollars in Thousands)					(Dollars in Thousands)
Within 30 days	$	93,835	1.76	%	Total	$	130,790	$	126,497	$	134,430	3.96	%
>30 days to 90 days	8,902		1.44
Total	$	102,737	1.73	%

At June 30, 2014, Linked Transactions also included approximately $481,000 of associated accrued interest receivable and $141,000 of accrued interest payable. At December 31, 2013, Linked Transactions also included approximately $210,000 of associated accrued interest receivable and $82,000 of accrued interest payable.

The following table presents certain information about the components of the unrealized net gains/(losses) and net interest income from Linked Transactions included in the Company’s consolidated statements of operations for the three and six months ended June 30, 2014 and 2013:



Components of Unrealized Net Gains and Net Interest Income from Linked Transactions	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2014			2013			2014			2013
Interest income attributable to MBS underlying Linked Transactions	$	2,925		$	654		$	4,966		$	1,322
Interest expense attributable to linked repurchase agreement borrowings underlying Linked Transactions	(921		)	(137		)	(1,472		)	(277		)
Change in fair value of Linked Transactions included in earnings	1,772			(812		)	3,533			196
Unrealized net gains/(losses) and net interest income from Linked Transactions	$	3,776		$	(295	)	$	7,027		$	1,241

Swaps

Consistent with market practice, the Company has agreements with its Swap counterparties that provide for the posting of collateral based on the fair values of its derivative contracts. Through this margining process, either the Company or its derivative counterparty may be required to pledge cash or securities as collateral. In addition, Swaps novated to and cleared by a central clearing house are subject to initial margin requirements. Certain derivative contracts provide for cross collateralization with repurchase agreements with the same counterparty.

A number of the Company’s Swap contracts include financial covenants, which, if breached, could cause an event of default or early termination event to occur under such agreements. Such financial covenants include minimum net worth requirements and maximum debt-to-equity ratios. If the Company were to cause an event of default or trigger an early termination event pursuant to one of its Swap contracts, the counterparty to such agreement may have the option to terminate all of its outstanding Swap contracts with the Company and, if applicable, any close-out amount due to the counterparty upon termination of the Swap contracts would be immediately payable by the Company. The Company was in compliance with all of its financial covenants through June 30, 2014. At June 30, 2014, the aggregate fair value of assets needed to immediately settle Swap contracts that were in a liability position to the Company, if so required, was approximately $59.7 million, including accrued interest payable of approximately $2.3 million.

The following table presents the assets pledged as collateral against the Company’s Swap contracts at June 30, 2014 and December 31, 2013:



(In Thousands)	June 30, 2014		December 31, 2013
Agency MBS, at fair value	$	75,061	$	73,859
Restricted cash	52,630		37,520
Total assets pledged against Swaps	$	127,691	$	111,379

The use of derivative hedging instruments exposes the Company to counterparty credit risk. In the event of a default by a derivative counterparty, the Company may not receive payments to which it is entitled under its derivative agreements, and may have difficulty recovering its assets pledged as collateral against such agreements. If, during the term of a derivative contract, a counterparty should file for bankruptcy, the Company may experience difficulty recovering its assets pledged as collateral which could result in the Company having an unsecured claim against such counterparty’s assets for the difference between the fair value of the derivative and the fair value of the collateral pledged to such counterparty.

The Company’s derivative hedging instruments, or a portion thereof, could become ineffective in the future if the associated repurchase agreements that such derivatives hedge fail to exist or fail to have terms that match those of the derivatives that hedge such borrowings.

The Company’s Swaps designated as hedging transactions have the effect of modifying the repricing characteristics of the Company’s repurchase agreements and cash flows for such liabilities. To date, no cost has been incurred at the inception of a Swap (except for certain transaction fees related to entering in to Swaps cleared though a central clearing house), pursuant to which the Company agrees to pay a fixed rate of interest and receive a variable interest rate, generally based on one-month or three-month London Interbank Offered Rate (“LIBOR”), on the notional amount of the Swap. The Company did not recognize any change in the value of its existing Swaps designated as hedges through earnings as a result of hedge ineffectiveness during the three and six months ended June 30, 2014 and 2013.

At June 30, 2014, the Company had Swaps designated in hedging relationships with an aggregate notional amount of $3.927 billion, which had net unrealized losses of $54.7 million, and extended 51 months on average with a maximum term of approximately 110 months.

The following table presents certain information with respect to the Company’s Swap activity during the three and six months ended June 30, 2014:



(Dollars in Thousands)	Three Months Ended June 30, 2014			Six Months Ended June 30, 2014
New Swaps:
Aggregate notional amount	$	200,000		$	400,000
Weighted average fixed-pay rate	1.96		%	1.95		%
Initial maturity date	5 years to 7 years			5 years to 7 years
Number of new Swaps	Two			Four
Swaps amortized/expired:
Aggregate notional amount	$	476,147		$	517,998
Weighted average fixed-pay rate	1.80		%	1.97		%

The following table presents information about the Company’s Swaps at June 30, 2014 and December 31, 2013:



	June 30, 2014						December 31, 2013
	Notional Amount		Weighted Average Fixed-Pay Interest Rate		Weighted Average Variable Interest Rate (2)		Notional Amount		Weighted Average Fixed-Pay Interest Rate		Weighted Average Variable Interest Rate (2)

Maturity (1)
(Dollars in Thousands)
Within 30 days	$	6,978	4.07	%	0.20	%	$	17,635	3.90	%	0.21	%
Over 30 days to 3 months	39,344		2.63		0.16		24,216		3.93		0.21
Over 3 months to 6 months	120,722		3.36		0.17		476,147		1.80		0.17
Over 6 months to 12 months	710,170		1.96		0.16		167,043		3.22		0.18
Over 12 months to 24 months	50,000		2.13		0.15		710,171		1.97		0.17
Over 24 months to 36 months	450,000		0.56		0.15		150,000		1.03		0.17
Over 36 months to 48 months	50,000		1.45		0.15		350,000		0.58		0.17
Over 48 months to 60 months	700,000		1.56		0.15		550,000		1.49		0.17
Over 60 months to 72 months	200,000		2.05		0.15		—		—		—
Over 72 months to 84 months	1,500,000		2.24		0.15		1,500,000		2.22		0.17
Over 84 months (3)	100,000		2.75		0.16		100,000		2.75		0.17
Total Swaps	$	3,927,214	1.91	%	0.15	%	$	4,045,212	1.91	%	0.17	%

(1) Each maturity category reflects contractual amortization and/or maturity of notional amounts.

(2) Reflects the benchmark variable rate due from the counterparty at the date presented, which rate adjusts monthly or quarterly based on one-month or three-month LIBOR, respectively.

(3) Reflects one Swap with a maturity date of July 2023.

The following table presents the net impact of the Company’s derivative hedging instruments on its interest expense and the weighted average interest rate paid and received for such Swaps for the three and six months ended June 30, 2014 and 2013:



	Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in Thousands)	2014			2013			2014			2013
Interest expense attributable to Swaps	$	18,075		$	12,027		$	35,638		$	24,996
Weighted average Swap rate paid	1.92		%	2.12		%	1.92		%	2.22		%
Weighted average Swap rate received	0.15		%	0.20		%	0.16		%	0.20		%

Impact of Derivative Hedging Instruments on AOCI

The following table presents the impact of the Company’s derivative hedging instruments on its AOCI for the three and six months ended June 30, 2014 and 2013:



	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2014			2013			2014			2013
AOCI from derivative hedging instruments:
Balance at beginning of period	$	(27,037	)	$	(50,515	)	$	(15,217	)	$	(62,831	)
Unrealized (loss)/gain on Swaps, net	(27,634		)	18,548			(39,901		)	30,864
Reclassification of unrealized loss on de-designated Swaps	—			—			447			—
Balance at end of period	$	(54,671	)	$	(31,967	)	$	(54,671	)	$	(31,967	)

Counterparty Credit Risk from Use of Swaps

By using Swaps, the Company is exposed to counterparty credit risk if counterparties to the derivative contracts do not perform as expected. If a counterparty fails to perform, the Company’s counterparty credit risk is equal to the amount reported as a derivative asset on its consolidated balance sheets to the extent that amount exceeds collateral obtained from the counterparty or, if in a net liability position, the extent to which collateral posted exceeds the liability to the counterparty. The amounts reported as a derivative asset/(liability) are derivative contracts in a gain/(loss) position, and to the extent subject to master netting arrangements, net of derivatives in a loss/(gain) position with the same counterparty and collateral received/(pledged). The Company attempts to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, executing master netting arrangements and obtaining collateral, where appropriate. Counterparty credit risk related to the Company’s Swaps is considered in determining fair value of such derivatives and its assessment of hedge effectiveness.