USE OF DERIVATIVES, OFFSETTING DISCLOSURES AND CHANGES IN OTHER COMPREHENSIVE INCOME BY COMPONENT | 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 occur in response to changes in market interest rates. During 2017 Capstead entered into swap agreements with notional amounts totaling $3.70 billion requiring fixed-rate interest payments averaging 1.64% for two- and three-year periods commencing on various dates between January 2017 and January 2018. Also during 2017, $3.80 billion notional amount of swaps requiring fixed-rate interest payments averaging 0.75% matured. At December 31, 2017, the Company’s portfolio financing-related swap positions had the following characteristics (dollars in thousands): Period of Contract Expiration Swap Notional Amounts Average Fixed Rates First quarter 2018 $ 1,700,000 0.76 % 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 300,000 1.82 Third quarter 2020 200,000 1.64 Fourth quarter 2020 200,000 2.04 $ 8,050,000 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 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 accordance with recent legal interpretations, exchange-traded swap agreements are now deemed to be settled daily. As a result, beginning in 2017, the fair value of exchange-traded swap agreements held as cash flow hedges of Secured borrowings Unsecured borrowings Cash collateral receivable from interest rate swap counterparties 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 December 31 Location 2017 2016 Balance sheet-related Swap agreements in a gain position (an asset) related to Secured borrowings (a) $ – $ 24,709 Swap agreements in a loss position (a liability) related to: Secured borrowings (a) – (222 ) Unsecured borrowings (a) (23,772 ) (24,195 ) Related net interest payable (b) (484 ) (11,989 ) $ (24,256 ) $ (11,697 ) (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 $22.4 million at December 31, 2017. (b) Included in “Accounts payable and accrued expenses” on the face of the Balance Sheets. Location of Gain or (Loss) Recognized in Year ended December 31 Net Income 2017 2016 2015 Income statement-related Components of Secured borrowings-related effects on interest expense: Amount of gain (loss) reclassified from Accumulated other comprehensive income $ 7,686 $ (17,180 ) $ (28,266 ) Amount of (loss) recognized in income (360 ) (1,236 ) (924 ) (a) 7,326 (18,416 ) (29,190 ) Component of Unsecured borrowings-related effects on interest expense: Amount of loss reclassified from Accumulated other comprehensive income (b) (2,878 ) (2,775 ) (284 ) Decrease (increase) in interest expense and increase (decrease) in Net income of Derivatives $ 4,448 $ (21,191 ) $ (29,474 ) Other comprehensive income-related Amount of gain (loss) recognized in Other comprehensive income $ 21,531 $ (1,370 ) $ (21,675 ) (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 the Balance Financial Collateral Net Assets (a) Sheet (a) Sheet Instruments Received Amount December 31, 2017 Counterparty 4 $ 30,676 $ (30,676 ) $ – $ – $ – $ – December 31, 2016 Counterparty 4 $ 18,100 $ 6,609 $ 24,709 $ (11,681 ) $ – $ 13,028 (a) Included in gross amounts of recognized assets at December 31, 2017 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 December 31, 2017. (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 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 ) $ – December 31, 2016 Derivatives by counterparty: Counterparty 1 $ 24,725 $ – $ 24,725 $ – $ (24,725 ) $ – Counterparty 4 5,072 6,609 11,681 (11,681 ) – – 29,797 6,609 36,406 (11,681 ) (24,725 ) – Borrowings under repurchase arrangements 12,151,122 – 12,151,122 (12,151,122 ) – – $ 12,180,919 $ 6,609 $ 12,187,528 $ (12,162,803 ) $ (24,725 ) $ – (a) Included in gross amounts of recognized liabilities at December 31, 2017 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 December 31, 2017. (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 $7.7 million and $7.4 million on borrowings under repurchases arrangements as of December 31, 2017 and December 31, 2016, respectively. Changes in Accumulated other comprehensive income Gains and Losses on Cash Flow Hedges Unrealized Gains and Losses on Available-for-Sale Securities Total Balance at December 31, 2014 $ (25,309 ) $ 252,731 $ 227,422 Activity for the year ended December 31, 2015: Other comprehensive income (loss) before reclassifications (21,675 ) (98,202 ) (119,877 ) Amounts reclassified from accumulated other comprehensive income 28,550 – 28,550 Other comprehensive income (loss) 6,875 (98,202 ) (91,327 ) Balance at December 31, 2015 (18,434 ) 154,529 136,095 Activity for the year ended December 31, 2016: Other comprehensive income (loss) before reclassifications (1,370 ) (48,894 ) (50,264 ) Amounts reclassified from accumulated other comprehensive income 19,955 – 19,955 Other comprehensive income (loss) 18,585 (48,894 ) (30,309 ) Balance at December 31, 2016 151 105,635 105,786 Activity for the year ended December 31, 2017: Other comprehensive income (loss) before reclassifications 21,426 (60,391 ) (38,965 ) Amounts reclassified from accumulated other comprehensive income (4,808 ) – (4,808 ) Cumulative effect adjustment 105 – 105 Other comprehensive income (loss) 16,723 (60,391 ) (43,668 ) Balance at December 31, 2017 $ 16,874 $ 45,244 $ 62,118 |