| Derivative Instruments | Note 6. Derivative Instruments In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative instruments. Derivative instruments are recorded at fair value as either “derivative assets” or “derivative liabilities” in the consolidated balance sheets, with all periodic changes in fair value reflected as a component of “investment gain (loss), net” in the consolidated statements of comprehensive income. Cash receipts or payments related to derivative instruments are classified as investing activities within the consolidated statements of cash flows. Types and Uses of Derivative Instruments Interest Rate Derivatives Most of the Company’s derivative instruments are interest rate derivatives that are intended to economically hedge changes, attributable to changes in benchmark interest rates, in certain MBS fair values and future interest cash flows on the Company’s short-term financing arrangements. Interest rate derivatives include centrally cleared interest rate swaps, exchange-traded instruments, such as Eurodollar futures, interest rate swap futures, U.S. Treasury note futures and options on futures, and nonexchange-traded instruments such as options on agency MBS. While the Company uses its interest rate derivatives to economically hedge a portion of its interest rate risk, it has not designated such contracts as hedging instruments for financial reporting purposes. The Company exchanges cash “variation margin” with the counterparties to its interest rate derivative instruments at least on a daily basis based upon daily changes in fair value as measured by the Chicago Mercantile Exchange (“CME”), the central clearinghouse through which those derivatives are cleared. In addition, the CME requires market participants to deposit and maintain an “initial margin” amount which is determined by the CME and is generally intended to be set at a level sufficient to protect the CME from the maximum estimated single-day price movement in that market participant’s contracts. Receivables recognized for the right to reclaim cash initial margin posted in respect of interest rate derivative instruments are included in the line item “deposits, net” in the accompanying consolidated balance sheets. Prior to January 1, 2017, the daily exchange of variation margin associated with centrally cleared derivative instruments was considered a pledge of collateral. For these prior periods, receivables recognized for the right to reclaim cash variation margin posted in respect of interest rate derivative instruments are included in the line item “deposits, net” in the accompanying consolidated balance sheets. The Company elected to offset any payables recognized for the obligation to return cash variation margin received from an interest rate derivative instrument counterparty against receivables recognized for the right to reclaim cash initial margin posted by the Company to that same counterparty. Beginning on January 1, 2017, as a result of a CME amendment to their rule book which governs their central clearing activities, the daily exchange of variation margin associated with a centrally cleared derivative instrument is legally characterized as the daily settlement of the derivative instrument itself, as opposed to a pledge of collateral. Accordingly, beginning in 2017, the Company accounts for the daily receipt or payment of variation margin associated with its centrally cleared interest rate swaps as a direct reduction to the carrying value of the interest rate swap derivative asset or liability, respectively. Beginning in 2017, the carrying amount of centrally cleared interest rate swaps reflected in the Company’s consolidated balance sheets is equal to the unsettled fair value of such instruments; because variation margin is exchanged on a one-day lag, the unsettled fair value of such instruments represents the change in fair value that occurred on the last day of the reporting period. To-Be-Announced Agency MBS Transactions, Including “Dollar Rolls” In addition to interest rate derivatives that are used for interest rate risk management, the Company is a party to derivative instruments that economically serve as investments, such as forward contracts to purchase fixed-rate “pass-through” agency MBS on a non-specified pool basis, which are known as to-be-announced (“TBA”) contracts. A TBA contract is a forward contract for the purchase or sale of a fixed-rate agency MBS at a predetermined price, face amount, issuer, coupon, and stated maturity for settlement on an agreed upon future date. The specific agency MBS that will be delivered to satisfy the TBA trade is not known at the inception of the trade. The Company accounts for TBA contracts as derivative instruments because the Company cannot assert that it is probable at inception and throughout the term of an individual TBA contract that its settlement will result in physical delivery of the underlying agency MBS, or the individual TBA contract will not settle in the shortest time period possible. The Company’s agency MBS investment portfolio includes net purchase (or “net long”) positions in TBA securities, which are primarily the result of executing sequential series of “dollar roll” transactions. The Company executes dollar roll transactions as a means of investing in and financing non-specified fixed-rate agency MBS. Such transactions involve effectively delaying (or “rolling”) the settlement of a forward purchase of a TBA agency MBS by entering into an offsetting sale prior to the settlement date, net settling the “paired-off” positions in cash, and contemporaneously entering another forward purchase of a TBA agency MBS of the same characteristics for a later settlement date. TBA securities purchased for a forward settlement month are generally priced at a discount relative to TBA securities sold for settlement in the current month. This discount, often referred to as the dollar roll “price drop,” reflects compensation for the net interest income (interest income less financing costs) that is foregone as a result of relinquishing beneficial ownership of the MBS for the duration of the dollar roll (also known as “dollar roll income”). By executing a sequential series of dollar roll transactions, the Company is able to create the economic experience of investing in an agency MBS, financed with a repurchase agreement, over a period of time. Forward purchases and sales of TBA securities are accounted for as derivative instruments in the Company’s financial statements. Accordingly, dollar roll income is recognized as a component of “investment gain (loss), net” along with all other periodic changes in the fair value of TBA commitments. In addition to transacting in net long positions in TBA securities for investment purposes, the Company may also, from time to time, transact in net sale (or “net short”) positions in TBA securities for the purpose of economically hedging a portion of the sensitivity of the fair value of the Company’s investments in agency MBS to changes in interest rates. Receivables recognized for the right to reclaim cash collateral posted by the Company in respect of TBA transactions is included in the line item “deposits, net” in the accompanying consolidated balance sheets. Liabilities recognized for the obligation to return cash collateral received by the Company in respect of TBA transactions is included in the line item “other liabilities” in the accompanying consolidated balance sheets. In addition to TBA transactions, the Company may, from time to time, enter into commitments to purchase or sell specified agency MBS that do not qualify as regular-way security trades. Such commitments are also accounted for as derivative instruments. Derivative Instrument Population and Fair Value The following table presents the fair value of the Company’s derivative instruments as of the dates indicated:
September 30, 2017
December 31, 2016
Assets
Liabilities
Assets
Liabilities
Interest rate swaps
$
3,348
$
—
$
63,315
$
(1,949
)
10-year U.S. Treasury note futures
820
—
—
—
Options on 10-year U.S. Treasury note futures
1
—
4,289
(3,906
)
Options on agency MBS
8
—
—
—
TBA commitments
—
(7,146
)
7,285
(3,699
)
Total
$
4,177
$
(7,146
)
$
74,889
$
(9,554
) Interest Rate Swaps The Company’s interest rate swap agreements represent agreements to make semiannual interest payments based upon a fixed interest rate and receive quarterly variable interest payments based upon the prevailing three-month LIBOR on the date of reset. The following table presents information about the Company’s interest rate swap agreements that were in effect as of September 30, 2017:
Weighted-average:
Notional Amount
Fixed Pay Rate
Variable Receive Rate
Net Receive (Pay) Rate
Remaining Life (Years)
Fair Value
Years to maturity:
Less than 3 years
$
1,300,000
1.26
%
1.32
%
0.06
%
1.7
$
447
3 to less than 7 years
700,000
1.87
%
1.32
%
(0.55
)%
4.1
844
7 to 10 years
1,600,000
1.90
%
1.32
%
(0.58
)%
8.5
1,963
Total / weighted-average
$
3,600,000
1.66
%
1.32
%
(0.34
)%
5.2
$
3,254
The following table presents information about the Company’s forward-starting interest rate swap agreements that had yet to take effect as of September 30, 2017:
Weighted-average:
Notional Amount
Fixed Pay Rate
Term After Effective Date (Years)
Fair Value
Effective in October 2017
$
250,000
1.12
%
2.0
$
94
The following table presents information about the Company’s interest rate swap agreements that were in effect as of December 31, 2016:
Weighted-average:
Notional Amount
Fixed Pay Rate
Variable Receive Rate
Net (Pay) Rate
Remaining Life (Years)
Fair Value
Years to maturity:
Less than 3 years
$
1,375,000
1.10
%
0.97
%
(0.13
)%
1.7
$
6,470
3 to less than 7 years
350,000
1.84
%
1.00
%
(0.84
)%
3.7
(769
)
7 to 10 years
1,600,000
1.93
%
0.96
%
(0.97
)%
9.2
50,511
Total / weighted-average
$
3,325,000
1.58
%
0.97
%
(0.61
)%
5.5
$
56,212
The following table presents information about the Company’s forward-starting interest rate swap agreements that had yet to take effect as of December 31, 2016:
Weighted-average:
Notional Amount
Fixed Pay Rate
Term After Effective Date (Years)
Fair Value
Effective in September / October 2017
$
375,000
1.13
%
2.0
$
5,154
10-year U.S. Treasury Note Futures The Company’s 10-year U.S. Treasury note futures held as of September 30, 2017, are short positions with an aggregate notional amount of $350,000 that mature in December 2017. Upon the maturity date of these futures contracts, the Company has the option to either net settle each contract in cash in an amount equal to the difference between the then-current fair value of the underlying 10-year U.S. Treasury note and the contractual sale price inherent to the futures contract, or to physically settle the contract by delivering the underlying 10-year U.S. Treasury note. Options on 10-year U.S. Treasury Note Futures The Company purchases and sells exchange-traded options on 10-year U.S. Treasury note futures contracts with the objective of economically hedging a portion of the sensitivity of its investments in agency MBS to significant changes in interest rates. The Company may purchase put options which provide the Company with the right to sell 10-year U.S. Treasury note futures to a counterparty, and the Company may also write call options that provide a counterparty with the option to buy 10-year U.S. Treasury note futures from the Company. In order to limit its exposure on its interest rate derivative instruments from a significant decline in long-term interest rates, the Company may also purchase contracts that provide the Company with the option to buy, or call, 10-year U.S. Treasury note futures from a counterparty. The options may be exercised at any time prior to their expiry, and if exercised, may be net settled in cash or through physical receipt or delivery of the underlying futures contracts. Information about the Company’s outstanding options on 10-year U.S. Treasury note futures contracts as of September 30, 2017 is as follows:
Notional Amount
Weighted-average Strike Price
Implied Strike Rate (1)
Net Fair Value
Purchased call options:
October 2017 expiration
$
150,000
133.0
1.49
%
$
1
(1)
The implied strike rate is estimated based upon the weighted average strike price per contract and the price of an equivalent 10-year U.S. Treasury note futures contract. Information about the Company’s outstanding options on 10-year U.S. Treasury note futures contracts as of December 31, 2016 is as follows:
Notional Amount
Weighted-average Strike Price
Implied Strike Rate (1)
Net Fair Value
Purchased put options:
January 2017 expiration
$
950,000
120.8
2.87
%
$
539
February 2017 expiration
700,000
122.6
2.64
%
3,281
Total / weighted average for purchased put options
$
1,650,000
121.6
2.77
%
$
3,820
Sold call options:
January 2017 expiration
$
(100,000
)
126.0
2.25
%
$
(141
)
February 2017 expiration
(900,000
)
126.0
2.24
%
(3,765
)
Total / weighted average for sold call options
$
(1,000,000
)
126.0
2.24
%
$
(3,906
)
Purchased call options:
January 2017 expiration
$
1,000,000
127.1
2.12
%
$
469
$
383
(1)
The implied strike rate is estimated based upon the weighted average strike price per contract and the price of an equivalent 10-year U.S. Treasury note futures contract. Options on Agency MBS The Company may purchase put options which provide the Company with the right to sell TBA-eligible agency MBS to a counterparty at a fixed price in the event that agency MBS prices decline. The options can only be exercised at their expiry, and if exercised, may be net settled in cash or through physical delivery of the underlying agency MBS. Information about the Company’s outstanding options on agency MBS as of September 30, 2017 is as follows:
Notional Amount
Weighted-average Strike Price
Underlying Agency MBS Coupon
Net Fair Value
Purchased put options:
October 2017 expiration
$
500,000
102.5
4.00
%
$
-
November 2017 expiration
200,000
103.5
4.00
%
8
Total / weighted average for purchased put options
$
700,000
102.8
4.00
%
$
8
TBA Commitments The following tables present information about the Company’s TBA commitments as of the dates indicated:
September 30, 2017
Notional Amount: Net Purchase (Sale) Commitment
Contractual Forward Price
Market Price
Fair Value
Dollar roll positions:
3.0% coupon purchase commitments
$
200,000
$
202,258
$
200,563
$
(1,695
)
3.5% coupon purchase commitments
1,005,000
1,040,762
1,036,092
(4,670
)
4.0% coupon purchase commitments
250,000
263,929
263,164
(765
)
4.0% coupon sale commitments
(100,000
)
(105,250
)
(105,266
)
(16
)
Total TBA commitments, net
$
1,355,000
$
1,401,699
$
1,394,553
$
(7,146
)
December 31, 2016
Notional Amount: Net Purchase (Sale) Commitment
Contractual Forward Price
Market Price
Fair Value
Dollar roll positions:
3.0% coupon purchase commitments
$
725,000
$
718,887
$
720,027
$
1,140
3.5% coupon purchase commitments
25,000
25,586
25,613
27
3.5% coupon sale commitments
(25,000
)
(25,602
)
(25,613
)
(11
)
Total dollar roll positions, net
725,000
718,871
720,027
1,156
TBA commitments serving as economic hedges:
3.5% coupon purchase commitments
600,000
608,601
614,719
6,118
3.5% coupon sale commitments
(600,000
)
(611,031
)
(614,719
)
(3,688
)
Total economic hedges, net
—
(2,430
)
—
2,430
Total TBA commitments, net
$
725,000
$
716,441
$
720,027
$
3,586
Derivative Instrument Gains and Losses The following tables provide information about the derivative gains and losses recognized within the periods indicated:
Three Months Ended September 30,
Nine Months Ended September 30,
2017
2016
2017
2016
Interest rate derivatives:
Interest rate swaps:
Net interest expense (1)
$
(4,198
)
$
(5,126
)
$
(14,900
)
$
(13,499
)
Unrealized gains (losses), net
10,833
15,426
(7,991
)
(65,519
)
Losses realized upon early termination
(14,137
)
(300
)
(13,441
)
(300
)
Total interest rate swap (losses) gains, net
(7,502
)
10,000
(36,332
)
(79,318
)
U.S. Treasury note futures, net
(133
)
—
(2,174
)
(63,285
)
Options on U.S. Treasury note futures, net
(147
)
(1,631
)
(6,300
)
(7,880
)
Other, net
(221
)
—
(221
)
(25
)
Total interest rate derivative (losses) gains, net
(8,003
)
8,369
(45,027
)
(150,508
)
TBA and specified agency MBS commitments:
TBA dollar roll income (2)
6,424
5,321
14,120
12,835
Other gains on agency MBS commitments, net
1,007
1,506
962
17,728
Total gains on agency MBS commitments, net
7,431
6,827
15,082
30,563
Total derivative (losses) gains, net
$
(572
)
$
15,196
$
(29,945
)
$
(119,945
)
(1)
Represents the periodic net interest settlement incurred during the period (often referred to as “net interest carry”). Beginning in 2017, also includes “price alignment interest” income earned or expense incurred on cumulative variation margin paid or received, respectively, associated with centrally cleared interest rate swap agreements.
(2)
Represents the price discount of forward-settling TBA purchases relative to a contemporaneously executed “spot” TBA sale, which economically equates to net interest income that is earned ratably over the period beginning on the settlement date of the sale and ending on the settlement date of the forward-settling purchase. Derivative Instrument Activity The following tables summarize the volume of activity, in terms of notional amount, related to derivative instruments for the periods indicated:
For the Three Months Ended September 30, 2017
Beginning of Period
Additions
Scheduled Settlements
Early Terminations
End of Period
Interest rate swaps
$
3,850,000
$
500,000
$
—
$
(500,000
)
$
3,850,000
10-year U.S. Treasury note futures
350,000
351,000
(351,000
)
—
350,000
Purchased call options on 10-year U.S. Treasury note futures
700,000
950,000
(1,500,000
)
—
150,000
Purchased put options on agency MBS
—
700,000
—
—
700,000
Commitments to purchase (sell) MBS, net
1,110,000
4,160,000
(3,915,000
)
—
1,355,000
For the Three Months Ended September 30, 2016
Beginning of Period
Additions
Scheduled Settlements
Early Terminations
End of Period
Interest rate swaps
$
2,250,000
$
1,250,000
$
—
$
(375,000
)
$
3,125,000
10-year U.S. Treasury note futures
—
15,000
(15,000
)
—
—
Purchased put options on 10-year U.S. Treasury note futures
2,000,000
2,100,000
(3,500,000
)
—
600,000
Sold call options on 10-year U.S. Treasury note futures
—
1,000,000
(400,000
)
—
600,000
Purchased call options on 10-year U.S. Treasury note futures
—
500,000
(200,000
)
—
300,000
Commitments to purchase (sell) MBS, net
875,441
2,675,000
(2,425,441
)
—
1,125,000
For the Nine Months Ended September 30, 2017
Beginning of Period
Additions
Scheduled Settlements
Early Terminations
End of Period
Interest rate swaps
$
3,700,000
$
1,275,000
$
—
$
(1,125,000
)
$
3,850,000
10-year U.S. Treasury note futures
—
1,196,100
(846,100
)
—
350,000
Purchased put options on 10-year U.S. Treasury note futures
1,650,000
2,540,000
(4,190,000
)
—
—
Sold call options on 10-year U.S. Treasury note futures
1,000,000
2,450,000
(3,450,000
)
—
—
Purchased call options on 10-year U.S. Treasury note futures
1,000,000
3,350,000
(4,200,000
)
—
150,000
Purchased put options on agency MBS
—
700,000
—
—
700,000
Commitments to purchase (sell) MBS, net
725,000
8,475,000
(7,845,000
)
—
1,355,000
For the Nine Months Ended September 30, 2016
Beginning of Period
Additions
Scheduled Settlements
Early Terminations
End of Period
Interest rate swaps
$
1,500,000
$
2,000,000
$
—
$
(375,000
)
$
3,125,000
10-year U.S. Treasury note futures
1,335,000
1,386,000
(2,133,500
)
(587,500
)
—
Purchased put options on 10-year U.S. Treasury note futures
—
8,100,000
(7,500,000
)
—
600,000
Sold call options on 10-year U.S. Treasury note futures
—
1,000,000
(400,000
)
—
600,000
Purchased call options on 10-year U.S. Treasury note futures
—
500,000
(200,000
)
—
300,000
Put options on Eurodollar futures
4,000,000
—
(4,000,000
)
—
—
Commitments to purchase (sell) MBS, net
375,000
6,225,441
(5,475,441
)
—
1,125,000
Cash Collateral Posted and Received for Derivative and Other Financial Instruments The following table presents information about the cash collateral posted and received by the Company in respect of its derivative and other financial instruments, which is included in the line item “deposits, net” in the accompanying consolidated balance sheets, for the dates indicated:
September 30, 2017
December 31, 2016
Cash collateral posted for:
Interest rate swaps (cash initial margin)
$
49,518
$
65,728
U.S. Treasury note futures and options on U.S. Treasury note futures (cash initial margin)
4,035
5,314
Unsettled MBS trades and TBA commitments, net
5,764
1,474
Total cash collateral posted
59,317
72,516
Cash collateral received for interest rate swaps (1)
—
(61,367
)
Total cash collateral posted, net
$
59,317
$
11,149
(1)
Beginning in 2017, the Company accounts for the daily receipt or payment of cash variation margin associated with centrally cleared interest rate swaps as a legal settlement of the derivative instrument itself, as opposed to a pledge of collateral. |
