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Derivatives and Hedging Activities
3 Months Ended
Mar. 31, 2017
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivatives and Hedging Activities
Derivatives and Hedging Activities
The following table summarizes changes in the notional amount of our derivative instruments during 2017:
$ in thousands
Notional Amount as
of January 1, 2017
 
Additions
 
Settlement,
Termination,
Expiration
or Exercise
 
Notional Amount as
of March 31, 2017
Interest Rate Swaps
6,500,000

 
1,150,000

 

 
7,650,000

Currency Forward Contracts
62,308

 
69,269

 
(65,576
)
 
66,001

Credit Derivatives
569,966

 

 
(3,007
)
 
566,959

Total
7,132,274

 
1,219,269

 
(68,583
)
 
8,282,960


Interest Rate Swaps
Our repurchase agreements are usually settled on a short-term basis ranging from one to twelve months. At each settlement date, we typically refinance each repurchase agreement at the market interest rate at that time. In addition, our secured loans have floating interest rates. As such, we are exposed to changing interest rates. Our objectives in using interest rate derivatives are to add stability to interest expense and to manage our exposures to interest rate movements. To accomplish this objective, we primarily use interest rate swaps as part of our interest rate risk management strategy. Interest rate swaps involve the receipt of variable-rate amounts from a counterparty in exchange for making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.
Effective December 31, 2013, we voluntarily discontinued cash flow hedge accounting for our interest rate swaps to gain greater flexibility in managing interest rate exposures. Amounts recorded in accumulated other comprehensive income (“AOCI”) before we discontinued cash flow hedge accounting for our interest rate swaps are reclassified to interest expense on repurchase agreements on the condensed consolidated statements of operations as interest is accrued and paid on the related repurchase agreements over the remaining life of the interest rate swap agreements. We reclassified $6.3 million as a decrease (March 31, 2016: $12.9 million as an increase) to interest expense for the three months ended March 31, 2017. During the next 12 months, we estimate that $25.8 million will be reclassified as a decrease to interest expense, repurchase agreements. As of March 31, 2017, $142.9 million (December 31, 2016: $149.1 million) of unrealized gain/(loss) on discontinued cash flow hedges, net is still included in accumulated other comprehensive income.
As of March 31, 2017, we had the following interest rate swaps outstanding:
$ in thousands
Counterparty
 
Notional
 
Maturity Date
 
Fixed Interest Rate
in Contract
ING Capital Markets LLC
 
350,000

 
2/24/2018
 
0.95
%
UBS AG
 
500,000

 
5/24/2018
 
1.10
%
ING Capital Markets LLC
 
400,000

 
6/5/2018
 
0.87
%
CME Central Clearing
 
300,000

 
2/5/2021
 
2.50
%
CME Central Clearing
 
300,000

 
2/5/2021
 
2.69
%
Wells Fargo Bank, N.A.
 
200,000

 
3/15/2021
 
3.14
%
CME Central Clearing
 
500,000

 
5/24/2021
 
2.25
%
Citibank, N.A.
 
200,000

 
5/25/2021
 
2.83
%
CME Central Clearing
 
500,000

 
6/24/2021
 
2.44
%
HSBC Bank USA, National Association
 
550,000

 
2/24/2022
 
2.45
%
CME Central Clearing
 
1,000,000

 
6/9/2022
 
2.21
%
The Royal Bank of Scotland Plc
 
500,000

 
8/15/2023
 
1.98
%
CME Central Clearing
 
600,000

 
8/24/2023
 
2.88
%
HSBC Bank USA, National Association
 
500,000

 
12/15/2023
 
2.20
%
CME Central Clearing
 
450,000

 
1/12/2024
 
2.10
%
CME Central Clearing
 
450,000

 
1/25/2024
 
2.15
%
CME Central Clearing
 
100,000

 
4/2/2025
 
2.04
%
CME Central Clearing
(1
)
250,000

 
5/24/2028
 
2.78
%
Total
 
7,650,000

 
 
 
2.16
%

(1)
Forward start date of 5/24/2018
Refer to Note 8 - "Collateral Positions" for further information regarding our collateral pledged to and received from our interest rate swap counterparties.
Interest Rate Swaptions
We have purchased interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the performance of a portion of our investment portfolio (referred to as “convexity risk”). The interest rate swaptions provide us 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. The premium paid for interest rate swaptions is reported as a derivative asset in our condensed consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the swaption is reported in gain (loss) on derivative instruments, net in our condensed consolidated statements of operations. If an interest rate swaption expires unexercised, the loss on the interest rate swaption would be equal to the premium paid. If we sell or exercise an interest rate swaption, the realized gain or loss on the interest rate swaption would be equal to the difference between the cash or the fair value of the underlying interest rate swap received and the premium paid.
As of March 31, 2017, we have no outstanding interest rate swaptions.
Currency Forward Contracts
We use currency forward contracts to help mitigate the potential impact of changes in foreign currency exchange rates on our investments denominated in foreign currencies. Realized and unrealized gains and losses associated with the purchases or sales of currency forward contracts are recognized in gain (loss) on derivative instruments, net in our condensed consolidated statements of operations.
Credit Derivatives
Our GSE CRTs purchased prior to August 24, 2015 are accounted for as hybrid financial instruments consisting of a debt host contract and an embedded credit derivative. Embedded derivatives associated with GSE CRTs are recorded within mortgage-backed and credit risk transfer securities, at fair value, on the consolidated balance sheets. At March 31, 2017 and December 31, 2016, terms of the GSE CRT embedded derivatives are:
$ in thousand
March 31, 2017
 
December 31, 2016
Fair value amount
31,243

 
17,095

Notional amount
566,959

 
569,966

Maximum potential amount of future undiscounted payments
566,959

 
569,966


Tabular Disclosure of the Effect of Derivative Instruments on the Balance Sheet
The table below presents the fair value of our derivative financial instruments, as well as their classification on the condensed consolidated balance sheets as of March 31, 2017 and December 31, 2016.
$ in thousands
Derivative Assets
 
Derivative Liabilities
 
 
As of March 31, 2017
 
As of December 31, 2016
 
 
 
As of March 31, 2017
 
As of December 31, 2016
Balance
Sheet
 
Fair Value
 
Fair Value
 
Balance
Sheet
 
Fair Value
 
Fair Value
Interest Rate Swaps Asset
 
5,387

 
3,085

 
Interest Rate Swaps Liability
 
45,404

 
133,833

Currency Forward Contracts
 
412

 
101

 
Currency Forward Contracts
 
219

 
395


Effective January 3, 2017, CME amended their rulebooks to legally characterize daily variation margin payments for centrally cleared interest rate swaps as settlement rather than collateral. As a result of this rule change, cash collateral pledged on our centrally cleared interest rate swaps is settled against the fair value of these swaps.
Tabular Disclosure of the Effect of Derivative Instruments on the Income Statement
The tables below present the effect of our credit derivatives on the condensed consolidated statements of operations for the three months ended March 31, 2017 and 2016.
$ in thousands
 
Three months ended March 31, 2017
Derivative
not designated as
hedging instrument
 
Realized gain (loss), net
 
GSE CRT embedded derivative coupon interest
 
Unrealized gain (loss), net
 
Realized and unrealized credit derivative income (loss), net
GSE CRT Embedded Derivatives
 

 
5,807

 
14,148

 
19,955

$ in thousands
 
Three months ended March 31, 2016
Derivative
not designated as
hedging instrument
 
Realized gain (loss), net
 
GSE CRT embedded derivative coupon interest
 
Unrealized gain (loss), net
 
Realized and unrealized credit derivative income (loss), net
GSE CRT Embedded Derivatives
 
(920
)
 
6,314

 
3,016

 
8,410

The following table summarizes the effect of interest rate swaps, interest rate swaptions and currency forward contracts reported in gain (loss) on derivative instruments, net on the condensed consolidated statements of operations for the three months ended March 31, 2017 and 2016:

$ in thousands
 
Three months ended March 31, 2017
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
15,994

 
(22,894
)
 
12,950

 
6,050

Currency Forward Contracts
 
(1,076
)
 

 
488

 
(588
)
Total
 
14,918

 
(22,894
)
 
13,438

 
5,462

$ in thousands
 
Three months ended March 31, 2016
Derivative
not designated as
hedging instrument
 
Realized gain (loss) on derivative instruments, net
 
 Contractual net interest expense
 
Unrealized gain (loss), net
 
Gain (loss) on derivative instruments, net
Interest Rate Swaps
 
(43,895
)
 
(29,091
)
 
(166,671
)
 
(239,657
)
Interest Rate Swaptions
 
(1,485
)
 

 
1,485

 

Currency Forward Contracts
 
2,395

 

 
(1,281
)
 
1,114

Total
 
(42,985
)
 
(29,091
)
 
(166,467
)
 
(238,543
)
Credit-risk-related Contingent Features
We have agreements with each of our bilateral derivative counterparties. Some of those agreements contain a provision whereby if we default on any of our indebtedness, including default whereby repayment of the indebtedness has not been accelerated by the lender, we could be declared in default on our derivative obligations.
At March 31, 2017, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for non-performance risk related to bilateral interest rate swap agreements, was $33.2 million. We have minimum collateral posting thresholds with certain of our derivative counterparties and have posted collateral of $42.4 million of Agency RMBS as of March 31, 2017. If we had breached any of these provisions at March 31, 2017, we could have been required to settle our obligations under the agreements at their termination value.
In addition, as of March 31, 2017, we have an agreement with a central clearing counterparty. The fair value of such derivatives in a net liability position, which includes accrued interest and variation margin but excludes any adjustment for non-performance risk related to this agreement, was $7.8 million.
We were in compliance with all of the financial provisions of these counterparty agreements as of March 31, 2017.