NOTE 6 — USE OF DERIVATIVES, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT

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 ended March 31, 2018, Capstead entered into swap agreements with notional amounts of $500 million requiring fixed-rate interest payments each averaging 2.44% for two and three-year periods commencing on various dates between February and April 2018. Also during the quarter ended March 31, 2018, $1.70 billion notional amount of swaps requiring fixed-rate interest payments averaging 0.76% matured. At March 31, 2018, 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
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		700,000		1.72
First quarter 2020		600,000		2.07
Second quarter 2020		100,000		2.56
Third quarter 2020		200,000		1.64
Fourth quarter 2020		200,000		2.04
First quarter 2021		100,000		2.67
	$	6,850,000

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.

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 are reported at fair value calculated excluding accrued interest. At March 31, 2018, 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.

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	March 31			December 31
	Location	2018			2017
Balance sheet-related
Swap agreements in a gain position (an asset) related to secured borrowings	(a)	$	387		$	–
Swap agreements in a loss position (a liability) related to
unsecured borrowings	(a)		(18,265	)		(23,772	)
Related net interest payable	(b)		(954	)		(484	)
		$	(18,832	)	$	(24,256	)

(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 $42.1 million at March 31, 2018.

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

	Location of Gain or (Loss) Recognized in	Quarter Ended March 31
	Net Income		2018			2017
Income statement-related
Components of Secured borrowings-related effects on interest expense:
Amount of gain (loss) reclassified from Accumulated other comprehensive income		$	5,247		$	(888	)
Amount of loss recognized in income		–				(393	)
	(a)		5,247			(1,281	)
Component of Unsecured borrowings-related effects on interest expense:
Amount of loss reclassified from Accumulated other comprehensive income	(b)		(603	)		(773	)
Decrease (increase) in interest expense and increase (decrease) in Net income as a result of the use of Derivatives		$	4,644		$	(2,054	)

Other comprehensive income-related
Amount of gain recognized in Other comprehensive income		$	30,933		$	8,096

(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 ^(b)

Amounts of

Offset in

Presented in

Cash

Recognized

the Balance

Financial

Collateral

Net

Assets ^(a)

Sheet ^(a)

Sheet

Instruments

Received

Amount

March 31, 2018

Counterparty 4

49,821

(49,434

)

387

–

387

December 31, 2017

Counterparty 4

30,676

(30,676

)

–

(a)	Included in gross amounts of recognized assets at March 31, 2018 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 March 31, 2018.

(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.

	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
March 31, 2018
Derivatives by counterparty:
Counterparty 1	$	19,219	$	–		$	19,219	$	–		$	(19,219	)	$	–
Counterparty 4		316		(316	)	–		–			–			–
		19,535		(316	)		19,219	–				(19,219	)	–
Borrowings under repurchase arrangements ^(d)		11,953,111	–				11,953,111		(11,953,111	)	–			–
	$	11,972,646	$	(316	)	$	11,972,330	$	(11,953,111	)	$	(19,219	)	$	–
December 31, 2017
Derivatives by counterparty:
Counterparty 1	$	24,256	$	–		$	24,256	$	–		$	(24,256	)	$	–
Counterparty 4		3,701		(3,701	)		–		–		–			–
		27,957		(3,701	)		24,256		–			(24,256	)	–
Borrowings under repurchase arrangements ^(d)		12,337,299	–				12,337,299		(12,337,299	)	–			–
	$	12,365,256	$	(3,701	)	$	12,361,555	$	(12,337,299	)	$	(24,256	)	$	–

(a)

Included in gross amounts of recognized liabilities at March 31, 2018 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 March 31, 2018.

(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 $9.5 million and $7.7 million on borrowings under repurchase arrangements as of March 31, 2018 and December 31, 2017, respectively.

Changes in Accumulated other comprehensive income by component for the quarter ended March 31, 2018 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 December 31, 2017	$	16,874		$	45,244		$	62,118
Activity for the quarter ended March 31, 2018:
Other comprehensive income (loss) before reclassifications		30,933			(44,053	)		(13,120	)
Amounts reclassified from accumulated other comprehensive income		(4,644	)	–				(4,644	)
Other comprehensive income (loss)		26,289			(44,053	)		(17,764	)
Balance at March 31, 2018	$	43,163		$	1,191		$	44,354