Derivative Financial Instruments

9 Months Ended

Sep. 30, 2012

Derivative Financial Instruments

Derivative Financial Instruments

Note 8 — Derivative Financial Instruments

Hedging Activities

The Company recognizes all derivatives as either assets or liabilities in the Consolidated Balance Sheets and measures those instruments at fair value.  Additionally, the fair value adjustments will affect either accumulated other comprehensive loss until the hedged item is recognized in earnings, or net income (loss) attributable to Arbor Realty Trust, Inc., depending on whether the derivative instrument qualifies as a hedge for accounting purposes and, if so, the nature of the hedging activity.  The ineffective portion of a derivative’s change in fair value is recognized immediately in earnings.

Derivatives

In connection with the Company’s interest rate risk management, the Company periodically hedges a portion of its interest rate risk by entering into derivative financial instrument contracts.  Specifically, the Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of its expected cash receipts and its expected cash payments principally related to its investments and borrowings.  The Company’s objectives in using interest rate derivatives are to add stability to interest income and to manage its exposure to interest rate movements.  To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy.  Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.  The Company has entered into various interest rate swap agreements to hedge its exposure to interest rate risk on (i) variable rate borrowings as it relates to fixed rate loans; (ii) the difference between the CDO investor return being based on the three-month LIBOR index while the supporting assets of the CDO are based on the one-month LIBOR index; and (iii) use of a LIBOR rate caps in loan agreements.

Derivative financial instruments must be effective in reducing the Company’s risk exposure in order to qualify for hedge accounting.  When the terms of an underlying transaction are modified, or when the underlying hedged item ceases to exist, all changes in the fair value of the instrument are marked-to-market with changes in value included in net income for each period until the derivative instrument matures or is settled.  In cases where a derivative financial instrument is terminated early, any gain or loss is generally amortized over the remaining life of the hedged item.  Any derivative instrument used for risk management that does not meet the hedging criteria is marked-to-market with the changes in value included in net income.  The Company does not use derivatives for trading or speculative purposes.

In certain circumstances, the Company may finance the purchase of RMBS investments through a repurchase agreement with the same counterparty which may qualify as a linked transaction if certain criteria are met.  The Company’s linked transactions are evaluated on a combined basis, reported as forward contract derivative instruments and included in other assets on the Consolidated Balance Sheets at fair value.  The fair value of linked transactions reflect the value of the underlying RMBS, 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 Consolidated Statement of Operations.

The following is a summary of the derivative financial instruments held by the Company as of September 30, 2012 and December 31, 2011 (dollars in thousands):

	Notional Value								Balance	Fair Value
Designation\ Cash Flow	Derivative	Count	September 30, 2012		Count	December 31, 2011		Expiration Date	Sheet Location	September 30, 2012			December 31, 2011
Non- Qualifying	Basis Swaps	8	$	634,524	9	$	854,079	2013 - 2015	Other Assets	$	405		$	1,563
Non- Qualifying	LIBOR Caps	2	$	13,000	2	$	13,000	2012 - 2013	Other Assets	$	—		$	1
Qualifying	LIBOR Cap	1	$	73,301	1	$	73,301	2013	Other Assets	$	—		$	1
Qualifying	Interest Rate Swaps	15	$	331,880	24	$	515,327	2012 - 2017	Other Liabilities	$	(41,081	)	$	(45,890	)
Non- Qualifying	Forward Contracts	8	$	—	—	$	—	2013 - 2030	Other Assets	$	4,473		$	—

The fair value of Non-Qualifying Basis Swap Hedges was $0.4 million and $1.6 million as of September 30, 2012 and December 31, 2011, respectively, and was recorded in other assets in the Consolidated Balance Sheets.  These basis swaps are used to manage the Company’s exposure to interest rate movements and other identified risks but do not meet hedge accounting requirements.  The Company is exposed to changes in the fair value of certain of its fixed rate obligations due to changes in benchmark interest rates and uses interest rate swaps to manage its exposure to changes in fair value on these instruments attributable to changes in the benchmark interest rate.  These interest rate swaps designated as fair value hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without the exchange of the underlying notional amount.  The fair value of the Non-Qualifying LIBOR Cap Hedges was less than $0.1 million at September 30, 2012 and December 31, 2011, and was recorded in other assets in the Consolidated Balance Sheets.  The Company entered into these hedges in the fourth quarter of 2010 and the first quarter of 2011 due to loan agreements which required LIBOR Caps of 1% to 2%.  During the nine months ended September 30, 2012, a basis swap matured with a notional value of approximately $110.1 million and the notional value of two basis swaps decreased by approximately $109.4 million pursuant to the contractual terms of the respective swap agreements.  During the nine months ended September 30, 2011, the notional value of two basis swaps decreased by approximately $128.9 million pursuant to the contractual terms of the respective swap agreements.  For the three months ended September 30, 2012 and 2011, the change in fair value of the Non-Qualifying Basis Swaps and LIBOR Caps was $(0.4) million and $0.4 million, respectively, and for the nine months ended September 30, 2012 and 2011, the change in fair value of the Non-Qualifying Basis Swaps and LIBOR Caps was $(1.2) million and $(0.2) million, respectively, and was recorded in interest expense on the Consolidated Statements of Operations.

The fair value of Qualifying Interest Rate Swap Cash Flow Hedges as of September 30, 2012 and December 31, 2011 was $(41.1) million and $(45.9) million, respectively, and was recorded in other liabilities in the Consolidated Balance Sheets.  The change in the fair value of Qualifying Interest Rate Swap Cash Flow Hedges was recorded in accumulated other comprehensive loss in the Consolidated Balance Sheets.  These interest rate swaps are used to hedge the variable cash flows associated with existing variable-rate debt, and amounts reported in accumulated other comprehensive loss related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt.  During the first quarter of 2011, the Company entered into a LIBOR Cap with a notional value of approximately $73.3 million that qualifies as a cash flow hedge.  The fair value of the Qualifying LIBOR Cap Hedge was less than $0.1 million at September 30, 2012 and is recorded in other assets in the Consolidated Balance Sheet.  The Company entered into this hedge due to a loan agreement which required a LIBOR Cap of 2%.  During the nine months ended September 30, 2012, nine interest rate swaps matured with a combined notional value of approximately $176.8 million and the notional value on an interest rate swap decreased by approximately $6.4 million pursuant to the contractual terms of the respective swap agreement.  During the nine months ended September 30, 2011, the notional value on two interest rate swaps decreased by approximately $14.2 million pursuant to the contractual terms of the respective swap agreements and five interest rate swaps matured with a combined notional value of approximately $78.2 million.  As of September 30, 2012, the Company expects to reclassify approximately $(14.5) million of other comprehensive loss from Qualifying Cash Flow Hedges to interest expense over the next twelve months assuming interest rates on that date are held constant.  Gains and losses on terminated swaps are being deferred and recognized in earnings over the original life of the hedged item.  These swap agreements must be effective in reducing the variability of cash flows of the hedged items in order to qualify for the aforementioned hedge accounting treatment.  As of September 30, 2012 and December 31, 2011, the Company has a net deferred loss of $2.4 million and $2.9 million, respectively, in accumulated other comprehensive loss.  The Company recorded $0.2 million and $0.4 million as additional interest expense related to the amortization of the loss for the three months ended September 30, 2012 and 2011, respectively, and $0.1 million and less than $0.1 million as a reduction to interest expense related to the accretion of the net gains for the three months ended September 30, 2012 and 2011, respectively.  The Company recorded $0.7 million and $1.3 million as additional interest expense related to the amortization of the loss for the nine months ended September 30, 2012 and 2011, respectively, and $0.2 million as a reduction to interest expense related to the accretion of the net gains for the nine months ended September 30, 2012 and 2011, respectively.  The Company expects to record approximately $0.7 million of net deferred loss to interest expense over the next twelve months.

The fair value of Non-Qualifying Forward Contracts was $4.5 million as of September 30, 2012 and was recorded in other assets in the Consolidated Balance Sheets and consisted of $47.4 million of RMBS investments, net of $43.0 million of repurchase financing.  There were no forward contracts as of December 31, 2011.  During the nine months ended September 30, 2012, the Company purchased eight RMBS investments for $52.2 million and financed generally 80% - 90% of the purchases with repurchase agreements totaling $46.1 million, which are accounted for as linked transactions and considered forward contracts.  The repurchase agreements bear interest at a rate of 125 to 175 basis points over LIBOR.  The Company received total principal paydowns on the RMBS of $4.8 million and paid down the associated repurchase agreement by $3.0 million.  For the nine months ended September 30, 2012, $0.5 million of net interest income and a $0.1 million increase in fair value was recorded to other income in the Consolidated Statement of Operations.  The RMBS investments bear interest at a weighted average fixed rate of 5.67%, have a weighted average stated maturity of 26.3 years, but have weighted average estimated lives of 5.0 years based on the estimated maturities of the RMBS investments, and have a combined fair value at September 30, 2012 of $4.5 million which is recorded in other assets on the Consolidated Balance Sheet.

The following table presents the effect of the Company’s derivative financial instruments on the Statements of Operations as of September 30, 2012 and 2011 (dollars in thousands):

		Amount of Loss Recognized in  Other Comprehensive Loss  (Effective Portion) For the Nine Months Ended				Amount of Loss Reclassified from  Accumulated Other Comprehensive Loss into Interest Expense (Effective Portion) For the Nine Months Ended						Amount of Gain (Loss) Recognized  in Interest Expense (Ineffective Portion) For the Nine Months Ended				Amount of Gain Recognized  in Other Income For the Nine Months Ended
Designation \Cash Flow	Derivative	September 30, 2012		September 30, 2011		September 30, 2012			September 30, 2011			September 30, 2012		September 30, 2011		September 30, 2012		September 30, 2011
Non-Qualifying	Basis Swaps / Caps	$	—	$	—	$	—		$	—		$	50	$	152	$	—	$	—
Qualifying	Interest Rate Swaps / Cap	$	7,507	$	19,559	$	(12,883	)	$	(20,918	)	$	—	$	—	$	—	$	—
Non-Qualifying	Forward Contracts	$	—	$	—	$	—		$	—		$	—	$	—	$	65	$	—

The cumulative amount of other comprehensive loss related to net unrealized losses on derivatives designated as qualifying hedges as of September 30, 2012 and December 31, 2011 of approximately $(43.5) million and approximately $(48.8) million, respectively, is a combination of the fair value of qualifying hedges of $(41.1) million and $(45.9) million, respectively, deferred losses on terminated interest swaps of $(3.0) million and $(3.7) million as of September 30, 2012 and December 31, 2011, respectively, and deferred net gains on termination of interest swaps of $0.6 million and $0.8 million as of September 30, 2012 and December 31, 2011, respectively.

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.  As of September 30, 2012 and December 31, 2011, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk related to these agreements, was $(20.5) million and $(22.0) million, respectively.  As of September 30, 2012 and December 31, 2011, the Company had minimum collateral posting thresholds with certain of its derivative counterparties and had posted collateral of $20.8 million and $21.9 million, respectively, which is recorded in other assets in the Company’s Consolidated Balance Sheets.