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

9 Months Ended

Sep. 30, 2015

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 6 ¾ USE OF DERIVATIVE FINANCIAL INSTRUMENTS, OFFSETTING

DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

In addition to entering into longer-maturity secured borrowings when available at attractive rates and terms, Capstead attempts to mitigate exposure to higher interest rates by entering into 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 secured borrowings.  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 designated 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, 2015 Capstead entered into swap agreements with notional amounts of $1.00 billion and $2.40 billion requiring fixed-rate interest payments averaging 0.80% and 0.76%, respectively, while $400 million and $1.70 billion notional amount of swaps requiring fixed-rate interest payments averaging 0.47% and 0.49%, respectively, matured.  At September 30, 2015, the Company’s 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 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
Fourth quarter 2016		800,000		0.66
First quarter 2017		1,000,000		0.72
Second quarter 2017		900,000		0.74
Third quarter 2017		400,000		0.74
		7,800,000		0.58
Forward-starting contracts:
Fourth quarter 2017		600,000		0.83
	$	8,400,000

In 2010 the Company entered into 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 30, 2015 and September 15, 2016 (see NOTE 7).  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.

Interest rate swap agreements are measured at fair value on a recurring basis primarily using Level Two Inputs in accordance with ASU 2010-06, Fair Value Measurements and Disclosures (Topic 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.  Related net interest payable at the balance sheet date is recorded separately.  The Company also incorporates both its own nonperformance risk and its counterparties’ nonperformance risk in determining fair value.  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.  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		2015			2014
Balance sheet-related
Swap agreements in a gain position (an asset) related to:
Secured borrowings	(a)	$	–		$	1,657
Swap agreements in a loss position (a liability) related to:
Secured borrowings	(a)		(14,462	)		(6,332	)
Unsecured borrowings	(a)		(26,778	)		(20,702	)
Related net interest payable	(b)		(9,475	)		(9,516	)
		$	(50,715	)	$	(34,893	)

(a) The fair value of Derivatives with unrealized gains are aggregated and recorded as an asset on the face of the Balance Sheets separately from the fair value of Derivatives with 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 $17.6 million at September 30, 2015.

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

	Location of Gain or (Loss) Recognized in Net Income		Quarter Ended September 30						Nine Months Ended September 30
			2015			2014			2015			2014
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			$	(7,183	)	$	(5,826	)	$	(20,494	)	$	(15,932	)
Amount of gain (loss) recognized (ineffective portion)				(336	)		45			(642	)		(123	)
Increase in interest expense and decrease in Net income as a result of the use of Derivatives		*	$	(7,519	)	$	(5,781	)	$	(21,136	)	$	(16,055	)
Other comprehensive income-related
Amount of gain (loss) recognized in Other comprehensive income (loss) (effective portion)			$	(21,235	)	$	97		$	(36,226	)	$	(25,557	)

* Included in “Interest expense:  Secured 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 5 for more information on the Company’s use of secured borrowings.  The following tables provide disclosures concerning offsetting of financial liabilities and Derivatives as of the indicated dates (in thousands):

	Offsetting of Derivative Assets
	Gross Amounts of Recognized Assets		Gross Amounts Offset in the Balance Sheet		Net Amounts of Assets Presented in the Balance Sheet		Gross Amounts Not Offset in the Balance Sheet (a)					Net Amount
							Financial Instruments			Cash Collateral Received
September 30, 2015
Counterparties 1-4	$	–	$	–	$	–	$	–		$	–	$	–
December 31, 2014
Counterparty 2	$	–	$	95	$	95	$	(95	)	$	–	$	–
Counterparty 4		1,128		434		1,562		(1,562	)		–		–
	$	1,128	$	529	$	1,657	$	(1,657	)	$	–	$	–

	Offsetting of Financial Liabilities and Derivative Liabilities
	Gross Amounts of Recognized Liabilities (b)		Gross Amounts Offset in the Balance Sheet		Net Amounts of Liabilities Presented in the Balance Sheet (a)		Gross Amounts Not Offset in the Balance Sheet (c)						Net Amount
							Financial Instruments			Cash Collateral Pledged
September 30, 2015
Derivatives by counterparty:
Counterparty 1	$	28,410	$	–	$	28,410	$	–		$	(28,410	)	$	–
Counterparty 2		2,816		–		2,816		–			(2,600	)		216
Counterparty 4		19,489		–		19,489		–			(19,489	)		–
		50,715		–		50,715		–			(50,499	)		216
Borrowings under repurchase arrangements		10,460,193		–		10,460,193		(10,460,193	)		–			–
	$	10,510,908	$	–	$	10,510,908	$	(10,460,193	)	$	(50,499	)	$	216
December 31, 2014
Derivatives by counterparty:
Counterparty 1	$	24,533	$	–	$	24,533	$	–		$	(24,533	)	$	–
Counterparty 2		4,042		95		4,137		(95	)		(4,042	)		–
Counterparty 3		736		–		736		–			(736	)		–
Counterparty 4		6,710		434		7,144		(1,562	)		(5,582	)		–
		36,021		529		36,550		(1,657	)		(34,893	)		–
Borrowings under repurchase arrangements		12,812,947		–		12,812,947		(12,812,947	)		–			–
	$	12,848,968	$	529	$	12,849,497	$	(12,814,604	)	$	(34,893	)	$	–

(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 $9.5 million and $9.5 million on interest rate swap agreements and $8.5 million and $6.1 million on  borrowings under repurchase arrangements, included in “Accounts payable and accrued expenses” on the face of the Balance Sheets as of September 30, 2015 and December 31, 2014, 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, 2015 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, 2015	$	(26,989	)	$	240,091		$	213,102
Activity for the quarter ended September 30, 2015:
Other comprehensive income (loss) before reclassifications		(21,235	)		(11,130	)		(32,365	)
Amounts reclassified from accumulated other comprehensive income		7,183			–			7,183
Other comprehensive income (loss)		(14,052	)		(11,130	)		(25,182	)
Balance at September 30, 2015	$	(41,041	)	$	228,961		$	187,920
Balance at December 31, 2014	$	(25,309	)	$	252,731		$	227,422
Activity for the nine months ended September 30, 2015:
Other comprehensive income (loss) before reclassifications		(36,226	)		(23,770	)		(59,996	)
Amounts reclassified from accumulated other comprehensive income		20,494			–			20,494
Other comprehensive income (loss)		(15,732	)		(23,770	)		(39,502	)
Balance at September 30, 2015	$	(41,041	)	$	228,961		$	187,920