NOTE 6 — USE OF DERIVATIVES, 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 one- and three-month LIBOR-indexed, pay-fixed, receive-variable, interest rate swap agreements. 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 any 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, 2017 Capstead entered into swap agreements with notional amounts of $650 million and $3.00 billion requiring fixed-rate interest payments each averaging 1.58% for two and three-year periods commencing on various dates between January and September 2017. Also during the quarter and nine months ended September 30, 2017, $400 million and $2.30 billion notional amount of swaps requiring fixed-rate interest payments averaging 0.74% and 0.73% matured. At September 30, 2017, the Company’s portfolio financing-related swap positions had the following characteristics (dollars in thousands):

Period of Contract Expiration	Notional Amount		Average Fixed-Rate Payment Requirement
Fourth quarter 2017	$	1,500,000		0.79	%
First quarter 2018		1,700,000		0.76
Second quarter 2018		600,000		0.79
Third quarter 2018		400,000		0.88
Fourth quarter 2018		800,000		1.15
First quarter 2019		950,000		1.58
Second quarter 2019		1,650,000		1.33
Third quarter 2019		550,000		1.40
Fourth quarter 2019		300,000		1.55
First quarter 2020		200,000		1.75
Third quarter 2020		200,000		1.64
	$	8,850,000

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. These Derivatives are designated as cash flow hedges of the variability of the underlying contractual rate associated with the floating-rate terms of these long-term borrowings which began on various dates between October 2015 and September 2016.

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. 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.

In accordance with recent legal interpretations, exchange-traded swap agreements are now deemed to be settled daily. As a result, beginning in 2017, the fair value of exchange-traded swap agreements held as cash flow hedges of Secured borrowings is calculated including accrued interest and net of variation margin amounts received or paid through the exchange, resulting in separately presenting on the balance sheet a significantly reduced fair value amount representing the unsettled fair value of these Derivatives. Non-exchange traded swap agreements held as cash flow hedges of Unsecured borrowings were not affected by these legal interpretations and continue to be reported at fair value calculated excluding accrued interest. At September 30, 2017, Cash collateral receivable from interest rate swap counterparties includes initial margin for all swap agreements and variation margin for non-exchange traded swap agreements. Accrued interest for non-exchange traded swap agreements is included in Accounts payable and accrued expenses. This change in presentation has had no further impact on the Company’s accounting for derivatives.

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	2017			2016
Balance sheet-related
Swap agreements in a gain position (an asset) related to: Secured borrowings	(a)	$	2,022		$	24,709
Swap agreements in a loss position (a liability) related to:
Secured borrowings	(a)	–				(222	)
Unsecured borrowings	(a)		(24,759	)		(24,195	)
Related net interest payable	(b)		(1,015	)		(11,989	)
		$	(23,752	)	$	(11,697	)

(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 gains, net of unrealized losses, scheduled to be recognized in the Statements of Income over the next twelve months primarily in the form of current market rates in excess of fixed-rate swap payments totaled $12.3 million at September 30, 2017.

(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		2017			2016			2017			2016
Income statement-related
Components of Secured borrowings-related effects on interest expense:
Amount of gain (loss) reclassified from Accumulated other comprehensive income		$	3,912		$	(4,261	)	$	4,412		$	(14,134	)
Amount of gain (loss) recognized in income			1,141			(323	)		(360	)		(1,210	)
	(a)		5,053			(4,584	)		4,052			(15,344	)
Component of Unsecured borrowings-related effects on interest expense:
Amount of loss reclassified from Accumulated other comprehensive income	(b)		(699	)		(666	)		(2,205	)		(1,973	)
Decrease (increase) in interest expense and increase (decrease) in Net income as a result of the use of Derivatives		$	4,354		$	(5,250	)	$	1,847		$	(17,317	)

Other comprehensive income-related
Amount of gain (loss) recognized in Other comprehensive income		$	1,827		$	12,558		$	3,541		$	(41,714	)

(a)

Included in “Interest expense: Secured borrowings” on the face of the Statements of Income.

(b)

Included in “Interest expense: Unsecured 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			Net Amounts		Gross Amounts Not Offset
	Gross		Amounts			of Assets		in the Balance Sheet ^(d)
	Amounts of		Offset in			Presented in					Cash
	Recognized		the Balance			the Balance		Financial			Collateral		Net
	Assets ^(c)		Sheet ^(c)			Sheet		Instruments			Received		Amount
September 30, 2017
Counterparty 4	$	16,461	$	(14,439	)	$	2,022	$	–		$	–	$	2,022
December 31, 2016
Counterparty 4	$	18,100	$	6,609		$	24,709	$	(11,681	)	$	–	$	13,028

(c)	Included in gross amounts of recognized assets at September 30, 2017 is the fair value of exchange-traded swap agreements, calculated including accrued interest. Included in gross amounts offset in the balance sheet are variation margin amounts associated with these swaps at September 30, 2017.

(d)	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.

	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 ^(a)		Sheet ^(a)			Sheet ^(b)		Instruments			Pledged			Amount
September 30, 2017
Derivatives by counterparty:
Counterparty 1	$	25,774	$	–		$	25,774	$	–		$	(25,774	)	$	–
Counterparty 4		5,597		(5,597	)	–		–			–			–
		31,371		(5,597	)		25,774	–				(25,774	)	–
Borrowings under repurchase arrangements ^(d)		12,470,704	–				12,470,704		(12,470,704	)	–			–
	$	12,502,075	$	(5,597	)	$	12,496,478	$	(12,470,704	)	$	(25,774	)	$	–
December 31, 2016
Derivatives by counterparty:
Counterparty 1	$	24,725	$	–		$	24,725	$	–		$	(24,725	)	$	–
Counterparty 4		5,072		6,609			11,681		(11,681	)	–			–
		29,797		6,609			36,406		(11,681	)		(24,725	)	–
Borrowings under repurchase arrangements ^(d)		12,151,122	–				12,151,122		(12,151,122	)	–			–
	$	12,180,919	$	6,609		$	12,187,528	$	(12,162,803	)	$	(24,725	)	$	–

(a)

Included in gross amounts of recognized liabilities at September 30, 2017 is the fair value of non-exchange traded swap agreements (Counterparty 1) and exchange-traded swap agreements (Counterparty 4), calculated including accrued interest. Included in gross amounts offset in the balance sheet are variation margin amounts associated with exchange-traded swap agreements at September 30, 2017.

(b)	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.

(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.

(d)	Amounts include accrued interest payable of $4.9 million and $7.4 million on borrowings under repurchase arrangements as of September 30, 2017 and December 31, 2016, respectively.

Changes in Accumulated other comprehensive income by component for the quarter and nine months ended September 30, 2017 were as follows (in thousands):

	Unrealized Gains and Losses on Cash Flow Hedges			Unrealized Gains and Losses on Available-for-Sale Securities			Total
Balance at June 30, 2017	$	2,871		$	98,211		$	101,082
Activity for the quarter ended September 30, 2017:
Other comprehensive income (loss) before reclassifications		1,827			(7,072	)		(5,245	)
Amounts reclassified from accumulated other comprehensive income		(3,213	)	–				(3,213	)
Other comprehensive income (loss)		(1,386	)		(7,072	)		(8,458	)
Balance at September 30, 2017	$	1,485		$	91,139		$	92,624

Balance at December 31, 2016	$	151		$	105,635		$	105,786
Activity for the nine months ended September 30, 2017:
Other comprehensive income (loss) before reclassifications		3,541			(14,496	)		(10,955	)
Amounts reclassified from accumulated other comprehensive income		(2,207	)	–				(2,207	)
Other comprehensive income (loss)		1,334			(14,496	)		(13,162	)
Balance at September 30, 2017	$	1,485		$	91,139		$	92,624