Derivative Financial Instruments

12 Months Ended

Dec. 31, 2013

Derivative Financial Instruments

Note 10. Derivative Financial Instruments

The following table presents the fair value and notional amount of derivative financial instruments held by us at December 31, 2013 and 2012. In the fourth quarter of 2012, we deconsolidated the Acacia entities and derecognized the associated assets and liabilities, including the derivative assets and liabilities owned by the Acacia entities. The derivatives held at Acacia entities are not assets or legal obligations of Redwood.

	December 31, 2013				December 31, 2012
(In Thousands)	Fair Value		Notional Amount		Fair Value		Notional Amount
Assets - Risk Management Derivatives
Interest rate swaps	$	5,972	$	268,000	$	739	$	147,000
TBAs		1,138		241,000		-		-
Futures		-		-		-		-
Swaptions		595		340,000		2,233		575,000
Loan purchase commitments		-		360		-		-
Loan forward sale commitments		81		10,000
Total Assets	$	7,786	$	859,360	$	2,972	$	722,000
Liabilities - Cash Flow Hedges
Interest rate swaps	$	(16,519)	$	139,500	$	(48,581)	$	139,500
Liabilities - Risk Management Derivatives
Interest rate swaps		(80)		50,500		(1,893)		357,500
TBAs		(661)		235,000		-		-
Futures		(528)		162,000		(607)		234,000
Loan purchase commitments		(379)		42,562		-		-
Total Liabilities	$	(18,167)	$	629,562	$	(51,081)	$	731,000
Total Derivative Financial Instruments, Net	$	(10,381)	$	1,488,922	$	(48,109)	$	1,453,000

Risk Management Derivatives

To offset, to varying degrees, risks associated with certain assets and liabilities on our consolidated balance sheets, 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 December 31, 2013, we were party to interest rate agreements with an aggregate notional amount of $648 million, TBA contracts sold with an aggregate notional amount of $476 million and financial futures contracts with an aggregate notional amount of $162 million. Net market valuation adjustments on risk management derivatives related to unsecuritized loans we own or plan to acquire were $51 million, negative $12 million, and negative $22 million for the years ended December 31, 2013, 2012, and 2011, respectively.

Certain Risks Related to Liabilities at Acacia Entities

Net valuation adjustments on interest rate agreements at Acacia were negative $11 million and negative $25 million for the years ended December 31, 2012 and 2011, respectively, and are reported through our consolidated statements of income in other market valuation adjustments, net.

Loan Purchase and Forward Sale Commitments

LPCs and FSCs that qualify as derivatives are recorded at their estimated fair values. Net valuation adjustments on LPCs and FSCs were less than negative $1 million for the year ended December 31, 2013, and are reported through our consolidated statements of income in mortgage banking activities, net.

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 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 years December 31, 2013, 2012, and 2011, these cash flow hedges increased in value by $32 million, $4 million, and decreased in value by $42 million, respectively, which was recorded in accumulated other comprehensive income, a component of equity. For interest rate agreements currently or previously designated as cash flow hedges, our total unrealized loss reported in accumulated other comprehensive income was $16 million and $48 million at December 31, 2013 and 2012, respectively. For the years ended December 31, 2013, 2012, and 2011, we reclassified less than $1 million, $15 million and $4 million, respectively, of unrealized losses on derivatives to interest expense. Concurrent with the derecognition of Acacia assets and liabilities in 2012, we accelerated our amortization of net unrealized losses on interest rate agreements and recognized interest expense of $11 million. Accumulated other comprehensive loss of less than $1 million will be amortized into interest expense, a component of our consolidated statements of income, 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 years ended December 31, 2013, 2012, and 2011.

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

	Year Ended December 31,
(In Thousands)	2013		2012		2011
Net interest expense on cash interest rate agreements	$	(5,889)	$	(5,805)	$	(6,392)
Realized expense due to ineffective portion of cash flow hedges		-		(34)		(4)
Realized net losses reclassified from other comprehensive income		(281)		(14,820)		(4,243)
Total Interest Expense	$	(6,170)	$	(20,659)	$	(10,639)

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 December 31, 2013, we assessed this risk as remote and did not record a specific valuation adjustment.

At December 31, 2013, we had outstanding derivative agreements with five counterparties and were in compliance with ISDA agreements governing our open derivative positions.