Derivative Financial Instruments

6 Months Ended

Jun. 30, 2013

Derivative Financial Instruments

Note 9. Derivative Financial Instruments

The following table presents the fair value and notional amount of derivative financial instruments held by us at June 30, 2013 and December 31, 2012.

	June 30, 2013				December 31, 2012
(In Thousands)	Fair Value		Notional Amount		Fair Value		Notional Amount
Assets - Risk Management Derivatives
Interest rate swaps	$	32,742	$	1,044,000	$	739	$	147,000
TBAs		8,655		345,000		-		-
Futures		328		30,000		-		-
Swaptions		1,616		615,000		2,233		575,000
Total Assets	$	43,341	$	2,034,000	$	2,972	$	722,000
Liabilities - Cash Flow Hedges
Interest rate swaps	$	(27,566)	$	139,500	$	(48,581)	$	139,500
Liabilities - Risk Management Derivatives
Interest rate swaps		(219)		20,500		(1,893)		357,500
TBAs		(1,139)		105,000		-		-
Futures		(647)		238,000		(607)		234,000
Total Liabilities	$	(29,571)	$	503,000	$	(51,081)	$	731,000
Total Derivative Financial Instruments, Net	$	13,770	$	2,537,000	$	(48,109)	$	1,453,000

Risk Management Derivatives

To offset, to varying degrees, risks associated with certain assets and liabilities on our consolidated balance sheet, we may enter into derivative contracts.

Certain Risks Related to Unsecuritized Residential and Commercial Loans at Redwood

In order to manage certain risks associated with residential and commercial loans we own or plan to acquire, at June 30, 2013, we were party to interest rate agreements with an aggregate notional amount of $1.7 billion, TBA contracts sold with an aggregate notional amount of $450 million and financial futures contracts with an aggregate notional amount of $268 million. Net market valuation adjustments on risk management derivatives related to unsecuritized loans we own or plan to acquire were positive $50 million and negative $3 million for the three months ended June 30, 2013 and 2012, respectively. Net market valuation adjustments on risk management derivatives related to unsecuritized loans we own or plan to acquire were positive $51 million and negative $7 million for the six months ended June 30, 2013 and 2012, respectively.

Derivatives Designated as Cash Flow Hedges

To hedge the variability in interest expense related to our long-term debt and certain adjustable-rate securitization entity liabilities that are included in our consolidated balance sheets for financial reporting purposes, we designated interest rate swaps as cash flow hedges during 2010 and during the second quarter of 2011 with an aggregate notional balance of $165 million. During the first half of 2012, we unwound swaps with an aggregate notional balance of $26 million that had been designated against certain adjustable-rate securitization entity liabilities.

For the three months ended June 30, 2013 and 2012, these cash flow hedges increased in value by $14 million and decreased in value by $16 million, respectively, which was recorded as an increase and decrease, respectively, to accumulated other comprehensive income, a component of equity. For the six months ended June 30, 2013 and 2012, these cash flow hedges increased in value by $21 million and decreased in value by $3 million, respectively. For interest rate agreements currently or previously designated as cash flow hedges, our total unrealized loss reported in accumulated other comprehensive income was $27 million and $48 million at June 30, 2013 and December 31, 2012, respectively. For the three months ended June 30, 2013 and 2012, we reclassified $69 thousand and $1 million, respectively, of unrealized losses on derivatives to interest expense. For the six months ended June 30, 2013 and 2012, we reclassified $157 thousand and $2 million, respectively, of unrealized losses on derivatives to interest expense. Accumulated other comprehensive loss of less than $1 million will be amortized into interest expense, a component of our consolidated income statements, over the remaining life of the hedged liabilities.

The following table illustrates the impact on interest expense of our interest rate agreements accounted for as cash flow hedges for the three and six months ended June 30, 2013 and 2012.

Impact on Interest Expense of Our Interest Rate Agreements Accounted for as Cash Flow Hedges

	Three Months Ended June 30,				Six Months Ended June 30,
(In Thousands)	2013		2012		2013		2012
Net interest expense on cash flow interest rate agreements	$	(1,470)	$	(1,437)	$	(2,934)	$	(2,953)
Realized income (expense) due to ineffective portion of hedges		-		5		-		(34)
Realized net losses reclassified from other comprehensive income		(69)		(1,098)		(157)		(2,134)
Total Interest Expense	$	(1,539)	$	(2,530)	$	(3,091)	$	(5,121)

Derivative Counterparty Credit Risk

We incur credit risk to the extent that counterparties to our derivative financial instruments do not perform their obligations under specified contractual agreements. If a derivative counterparty does not perform, we may not receive the proceeds to which we may be entitled under these agreements. Each of our derivative counterparties must maintain compliance with International Swaps and Derivatives Association (“ISDA”) agreements (or receive a waiver of non-compliance after a specific assessment) in order to conduct derivative transactions with us. Additionally, we review derivative counterparty credit standings, and in the case of a deterioration of creditworthiness, appropriate remedial action is taken. To further mitigate counterparty risk, we exit derivatives contracts with counterparties that (i) do not maintain compliance with (or obtain a waiver from) the terms of their ISDA agreements with us; or (ii) do not maintain their status as a primary government dealer or affiliate by the U.S. Department of Treasury or do not meet internally established guidelines regarding credit worthiness. Our ISDA agreements currently require full bilateral collateralization of unrealized loss exposures with our derivative counterparties. Through a margin posting process, our positions are revalued with counterparties each business day and cash margin is generally transferred to either us or our derivative counterparties as collateral based upon the directional changes in fair value of the positions. We also attempt to transact with several different counterparties in order to reduce our specific counterparty exposure. We consider counterparty risk as part of our fair value assessments of all derivative financial instruments. At June 30, 2013, we assessed this risk as remote and did not record a specific valuation adjustment.

At June 30, 2013, we had outstanding derivative agreements with six counterparties and were in compliance with ISDA agreements governing our open derivative positions.