USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

9 Months Ended

Sep. 30, 2014

USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT [Abstract]

USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

NOTE 7 ¾ USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

To help mitigate exposure to higher interest rates, Capstead typically uses currently-paying and forward-starting, one-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements that require interest payments for two-year terms.  These Derivatives are designated as cash flow hedges of the variability of the underlying benchmark interest rate of current and forecasted 30- to 90-day borrowings under repurchase arrangements.  This hedge relationship establishes a relatively stable fixed rate on related borrowings because the variable-rate payments received on the swap agreements offset a significant portion of the interest accruing on the related borrowings, leaving the fixed-rate swap payments as the Company’s effective borrowing rate, subject to certain adjustments.  These adjustments include differences between variable rate payments received on the swap agreements and related unhedged borrowing rates as well as the effects of measured hedge ineffectiveness.  Additionally, changes in fair value of these Derivatives tend to partially offset opposing changes in fair value of the Company’s residential mortgage investments that can occur in response to changes in market interest rates.

During the quarter and nine months ended September 30, 2014 Capstead entered into new forward-starting swap agreements with notional amounts totaling $500 million and $1.90 billion, respectively.  These swap agreements require fixed rate interest payments averaging 0.72% and 0.61%, respectively, for two-year periods commencing on various dates between April 2014 and January 2015.  Also during these periods, $200 million and $800 million notional amount of swaps requiring fixed rate interest payments averaging 0.51% and 0.53%, respectively, matured, while $700 million and $3.50 billion notional amount of previously-acquired, forward-starting swaps requiring fixed rate interest payments averaging 0.56% and 0.51%, respectively, moved into current-pay status.  At September 30, 2014, the Company’s portfolio of financing-related swap positions had the following characteristics (dollars in thousands):

Period of Contract Expiration	Notional Amount		Average Fixed Rate Payment Requirement
Currently-paying contracts:
Fourth quarter 2014	$	500,000		0.58	%
First quarter 2015		1,100,000		0.50
Second quarter 2015		200,000		0.43
Third quarter 2015		400,000		0.47
Fourth quarter 2015		1,200,000		0.45
First quarter 2016		1,700,000		0.51
Second quarter 2016		1,100,000		0.47
Third quarter 2016		700,000		0.56
(average expiration:  13 months)		6,900,000		0.50
Forward-starting contracts:
Fourth quarter 2016		800,000		0.66
First quarter 2017		100,000		0.90
(average expiration:  24 months)		900,000		0.69
(average expiration:  14 months)	$	7,800,000

In addition to portfolio financing-related swap positions, in 2010 the Company entered into three forward-starting, three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements with notional amounts totaling $100 million and average fixed rates of 4.09% with 20-year payment terms coinciding with the floating-rate terms of the Company’s Unsecured borrowings which begin between October 2015 and September 2016.  These Derivatives are designated as cash flow hedges of the variability of the underlying benchmark interest rate associated with the floating-rate terms of these long-term borrowings (see NOTE 8).

Interest rate swap agreements are measured at fair value on a recurring basis primarily using Level Two Inputs in accordance with “Fair Value Measurements and Disclosures” (“ASC 820”).  In determining fair value estimates for these Derivatives, Capstead utilizes the standard methodology of netting the discounted future fixed cash payments and the discounted future variable cash receipts which are based on expected future interest rates derived from observable market interest rate curves.  The Company also incorporates both its own nonperformance risk and its counterparties’ nonperformance risk in determining the fair value of these Derivatives.  In considering the effect of nonperformance risk, the Company considered the impact of netting and credit enhancements, such as collateral postings and guarantees, and has concluded that counterparty risk is not significant to the overall valuation of these agreements.

The following tables include fair value and other related disclosures regarding all Derivatives held as of and for the indicated periods (in thousands):

	Balance Sheet	September 30,			December 31,
	Location	2014			2013
Balance sheet-related
Swap agreements in a gain position (an asset) related to:
Borrowings under repurchase arrangements	(a)	$	2,397		$	1,094
Unsecured borrowings	(a)		–			3,911
Swap agreements in a loss position (a liability) related to:
Borrowings under repurchase arrangements	(a)		(7,026	)		(11,304	)
Unsecured borrowings	(a)		(11,250	)		–
Related net interest payable	(b)		(8,916	)		(5,493	)
		$	(24,795	)	$	(11,792	)

(a) The fair value of Derivatives with realized and unrealized gains are aggregated and recorded as an asset on the face of the Balance Sheets separately from the fair value of Derivatives with realized and unrealized losses that are recorded as a liability.  The amount of unrealized losses scheduled to be recognized in the Statements of Income over the next twelve months primarily in the form of fixed-rate swap payments in excess of current market rates totaled $15.5 million at September 30, 2014.

(b) Included in “Accounts payable and accrued expenses” on the face of the Balance Sheets.

	Location of
	Gain or (Loss)
	Recognized  in		Quarter Ended September 30						Nine Months Ended September 30
	Net Income		2014			2013			2014			2013
Income statement-related
Components of effect on interest expense:
Amount of loss reclassified from Accumulated other comprehensive income related to the effective portion of active positions			$	(5,826	)	$	(3,698	)	$	(15,932	)	$	(13,548	)
Amount of gain (loss) recognized (ineffective portion)				45			(23	)		(123	)		73
Increase in interest expense and decrease in Net income as a result of the use of Derivatives		*	$	(5,781	)	$	(3,721	)	$	(16,055	)	$	(13,475	)
Other comprehensive income-related
Amount of gain (loss) recognized in Other comprehensive income(loss) (effective portion)			$	97		$	(10,867	)	$	(25,557	)	$	9,136

* Included in “Interest expense:  Repurchase arrangements and similar borrowings” on the face of the Statements of Income.

Capstead’s swap agreements and borrowings under repurchase arrangements are subject to master netting arrangements in the event of default on, or termination of, any one contract.  See NOTE 6 for more information on the Company’s use of repurchase arrangements.  The following tables provide disclosures concerning offsetting of financial liabilities and Derivatives as of the indicated dates (in thousands):

	Offsetting of Derivative Assets
			Gross		Net Amounts		Gross Amounts Not Offset
	Gross		Amounts		of Assets		in the Balance Sheet(a)
	Amounts of		Offset in		Presented in					Cash
	Recognized		the Balance		the Balance		Financial			Collateral		Net
	Assets		Sheet		Sheet		Instruments			Received		Amount
As of September 30, 2014:
Counterparty 2	$	–	$	262	$	262	$	(262	)	$	–	$	–
Counterparty 4		1,373		762		2,135		(2,135	)		–		–
	$	1,373	$	1,024	$	2,397	$	(2,397	)	$	–	$	–
As of December 31, 2013:
Counterparty 1	$	3,911	$	–	$	3,911	$	(3,911	)	$	–	$	–
Counterparty 2		634		–		634		(634	)		–		–
Counterparty 4		460		–		460		(460	)		–		–
	$	5,005	$	–	$	5,005	$	(5,005	)	$	–	$	–

	Offsetting of Financial Liabilities and Derivative Liabilities
			Gross		Net Amounts		Gross Amounts Not Offset
	Gross		Amounts		of Liabilities		in the Balance Sheet (c)
	Amounts of		Offset in		Presented in					Cash
	Recognized		the Balance		the Balance		Financial			Collateral			Net
	Liabilities(b)		Sheet		Sheet (a)		Instruments			Pledged			Amount
As of September 30, 2014:
Derivatives by counterparty:
Counterparty 1	$	15,785	$	–	$	15,785	$	–		$	(15,785	)	$	–
Counterparty 2		5,316		262		5,578		(262	)		(5,316	)		–
Counterparty 3		620		–		620		–			(620	)		–
Counterparty 4		4,447		762		5,209		(2,135	)		(3,074	)		–
		26,168		1,024		27,192		(2,397	)		(24,795	)		–
Repurchase arrangements and similar borrowings		12,752,311		–		12,752,311		(12,752,311	)		–			–
	$	12,778,479	$	1,024	$	12,779,503	$	(12,754,708	)	$	(24,795	)	$	–
As of December 31, 2013:
Derivatives by counterparty:
Counterparty 1	$	6,002	$	–	$	6,002	$	(3,911	)	$	(2,091	)	$	–
Counterparty 2		6,352		–		6,352		(634	)		(5,718	)		–
Counterparty 3		1,581		–		1,581		–			(1,581	)		–
Counterparty 4		2,862		–		2,862		(460	)		(2,402	)		–
		16,797		–		16,797		(5,005	)		(11,792	)		–
Repurchase arrangements and similar borrowings		12,487,604		–		12,487,604		(12,487,604	)		–			–
	$	12,504,401	$	–	$	12,504,401	$	(12,492,609	)	$	(11,792	)	$	–

(a) Amounts presented are limited to recognized liabilities and cash collateral received associated with the indicated counterparty sufficient to reduce the related Net Amount to zero in accordance with ASU No. 2011-11, as amended by ASU No. 2013-01.

(b) Amounts include accrued interest of $8.9 million and $5.5 million on interest rate swap agreements and $2.5 million and $4.7 million on repurchase arrangements and similar borrowings, included in “Accounts payable and accrued expenses” on the face of the Balance Sheets as of September 30, 2014 and December 31, 2013, respectively.

(c) Amounts presented are limited to recognized assets and collateral pledged associated with the indicated counterparty sufficient to reduce the related Net Amount to zero in accordance with ASU No. 2011-11, as amended by ASU No. 2013-01.

Changes in Accumulated other comprehensive income by component for the quarter and nine months ended September 30, 2014 were as follows (in thousands):

	Gains and Losses on Cash Flow Hedges			Unrealized Gains and Losses on Available-for-Sale Securities			Total
Balance at June 30, 2014	$	(21,853	)	$	258,633		$	236,780
Activity for the quarter ended September 30, 2014:
Other comprehensive income (loss) before reclassifications		97			(10,720	)		(10,623	)
Amounts reclassified from accumulated other comprehensive income		5,826			–			5,826
Other comprehensive income (loss)		5,923			(10,720	)		(4,797	)
Balance at September 30, 2014	$	(15,930	)	$	247,913		$	231,983
Balance at December 31, 2013	$	(6,305	)	$	225,448		$	219,143
Activity for the nine months ended September 30, 2014:
Other comprehensive income (loss) before reclassifications		(25,557	)		22,465			(3,092	)
Amounts reclassified from accumulated other comprehensive income		15,932			–			15,932
Other comprehensive income (loss)		(9,625	)		22,465			12,840
Balance at September 30, 2014	$	(15,930	)	$	247,913		$	231,983