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

Capstead’s portfolio of derivative financial instruments (“Derivatives”) hedge the variability of the underlying benchmark interest rate of current and forecasted 30- to 90-day secured borrowings. The Company attempts to mitigate exposure to higher interest rates primarily by entering into three-month LIBOR- or OIS-indexed, pay-fixed, receive-variable, interest rate swap agreements for terms between eighteen months and three years. From an economic perspective, 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 borrowings, leaving the fixed-rate swap payments as the Company’s effective borrowing rate, subject to certain adjustments. 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.

The Company discontinued hedge accounting in 2019 for its secured borrowings-related interest rate swaps and, for GAAP purposes, related changes in the fair value are recognized in the Company’s consolidated statements of operations beginning on the de-designation date. Also, for GAAP purposes, related unrealized gains and losses recorded in Accumulated other comprehensive income through the de-designation date are being recognized as a component of interest expense in the Company’s Consolidated Statements of Operations over the remaining lives of these swaps.

During the quarter and six months ended June 30, 2020, Capstead entered into swap agreements with notional amounts of $400 million and $3.20 billion, respectively, requiring fixed-rate interest payments averaging 0.02% and 1.00%. The Company terminated $5.2 billion notional amount of swaps requiring fixed-rate interest payments averaging 1.67% during the six months ended June 30, 2020, all during the first quarter. Also during the quarter and six months ended June 30, 2020, $200 million and $800 million notional amount of swaps requiring fixed-rate interest payments averaging 2.56% and 2.20% matured. At June 30, 2020 the Company’s swap positions related to secured borrowings had the following characteristics (dollars in thousands):

Subsequent to June 30, 2020, the Company terminated all swaps scheduled to mature in the third and fourth quarters of 2020 and the fourth quarter of 2021 as well as $100 million notional amount scheduled to mature in the third quarter of 2021 totaling $1.4 billion notional amount of swaps requiring fixed-rate interest payments averaging 1.67%.

The Company has 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 payment terms coinciding with the floating-rate terms of the Company’s Unsecured borrowings that mature in 2035 and 2036. These Derivatives, which are designated as cash flow hedges for accounting purposes, hedge the variability of the underlying contractual 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 2 Inputs in accordance with ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820). Fair value estimates for these Derivatives are calculated using the net 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. Eurodollar futures are measured at fair value using Level 1 inputs based on quoted exchange prices on these contracts. 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 hedging 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. Cash collateral receivable from derivative 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	June 30			December 31
	Location	2020			2019
Balance sheet-related
Swap agreements in a gain position (an asset) related to secured borrowings	(a)	$	–		$	733
Eurodollar futures contracts in a gain position	(a)	–				738
Swap agreements in a loss position (a liability) related to
unsecured borrowings	(a)		(49,575	)		(29,156	)
Related net interest payable	(b)		(559	)		(437	)
		$	(50,134	)	$	(28,122	)

	Location of Gain or (Loss) Recognized in	Quarter Ended June 30						Six Months Ended June 30
	Net Income		2020			2019			2020			2019
Income statement-related
Components of Secured borrowings-related effects on interest expense:
Amount of gain reclassified from Accumulated other comprehensive income		$	–		$	–		$	–		$	7,891
Amortization of unrealized gain, net of unrealized losses on de-designated Derivatives			(122	)		6,715			(19	)	$	9,735
	(a)		(122	)		6,715			(19	)		17,626
Component of Unsecured borrowings-related effects on interest expense:
Amount of loss reclassified from Accumulated other comprehensive income	(b)		(817	)		(364	)		(1,399	)		(704	)
(Increase) decrease in interest expense as a result of the use of Derivatives		$	(938	)	$	6,351		$	(1,418	)	$	16,922

Realized and unrealized loss on non-designated Derivatives (net) related to:
Interest rate swap agreements		$	(6,664	)	$	(74,842	)	$	(159,888	)	$	(96,499	)
Eurodollar futures			(284	)	–				(2,799	)	–
	(c)	$	(6,948	)	$	(74,842	)	$	(162,687	)	$	(96,499	)

Other comprehensive income-related
Amount of loss recognized in Other comprehensive income		$	(567	)	$	(6,746	)	$	(21,818	)	$	(15,297	)

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

June 30, 2020

Counterparty 4

–

December 31, 2019

Counterparty 4

6,517

(5,046

)

1,471

–

1,471

	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
June 30, 2020
Derivatives by counterparty:
Counterparty 1	$	50,134	$	–		$	50,134	$	–		$	(50,134	)	$	–
Counterparty 4		72,609		(72,609	)	–		–			–			–
		122,743		(72,609	)		50,134	–				(50,134	)	–
Borrowings under repurchase arrangements ^(d)		7,575,101	–				7,575,101		(7,575,101	)	–			–
	$	7,697,844	$	(72,609	)	$	7,625,235	$	(7,575,101	)	$	(50,134	)	$	–
December 31, 2019
Derivatives by counterparty:
Counterparty 1	$	29,593	$	–		$	29,593	$	–		$	(29,593	)	$	–
Counterparty 4		21,601		(21,601	)		–		–		–			–
		51,194		(21,601	)		29,593		–			(29,593	)	–
Borrowings under repurchase arrangements ^(d)		10,286,011	–				10,286,011		(10,286,011	)	–			–
	$	10,337,205	$	(21,601	)	$	10,315,604	$	(10,286,011	)	$	(29,593	)	$	–

The amount of unrealized losses, net of unrealized gains, included in Accumulated other comprehensive income (loss) and scheduled to be recognized in the Consolidated Statements of Operations over the next twelve months primarily in the form of a fixed-rate swap payments in excess of current market rates on swaps related to unsecured borrowings and amortization of net unrealized losses on de-designated interest

rate swaps totaled $5.6 million at June 30, 2020. Changes in Accumulated other comprehensive income by component for the quarter and six months ended June 30, 2020 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 March 31, 2020	$	(52,639	)	$	46,361		$	(6,278	)
Activity for the quarter ended June 30, 2020:
Other comprehensive loss (income) before reclassifications		(567	)		64,659			64,092
Amounts reclassified from accumulated other comprehensive income		938			—			938
Other comprehensive income		371			64,659			65,030
Balance at June 30, 2020	$	(52,268	)	$	111,020		$	58,752

Balance at December 31, 2019	$	(31,868	)	$	45,267		$	13,399
Activity for the six months ended June 30, 2020:
Other comprehensive loss before reclassifications		(21,818	)		(1,111	)		(22,929	)
Amounts reclassified from accumulated other comprehensive income		1,418			66,864			68,282
Other comprehensive (loss) income		(20,400	)		65,753			45,353
Balance at June 30, 2020	$	(52,268	)	$	111,020		$	58,752