counterparties and adjusting posted collateral as required.
Discontinuation of hedge accounting for interest rate swap agreements
Prior to the third quarter of 2011, we entered into interest rate swap agreements typically with the intention of qualifying for hedge accounting under ASC 815. However, as of September 30, 2011, we elected to discontinue hedge accounting for our interest rate swaps in order to increase our funding flexibility. For our interest rate swaps to qualify as cash flow hedges pursuant to ASC 815, their monthly reset dates were required to align with the term of an underlying repurchase agreement. This alignment had the effect of limiting our ability to alter or extend the maturity of our repurchase agreements. To provide greater funding flexibility, we determined that it was not beneficial to always match the pricing dates of our swaps and repurchase agreements and, thus, elected to discontinue hedge accounting. Our net asset value was not impacted by our election to discontinue hedge accounting since our net asset value is the same irrespective of whether we apply hedge accounting.
Upon discontinuation of hedge accounting, the net deferred loss related to our de-designated interest rate swaps remained in accumulated OCI. Following hedge de-designation, on September 30, 2011, the net deferred loss is reclassified from accumulated OCI into interest expense on a straight-line basis over the remaining term of each interest rate swap. However, although the reclassification of accumulated OCI into interest expense is similar to as if the interest rate swaps had not been de-designated, the actual net periodic interest costs associated with our de-designated interest rates swaps may be more or less than amounts reclassified into interest expense. The difference, as well as net periodic interest costs on interest rate swaps that were never in a hedge designation, along with subsequent changes in the fair value of our interest rates swaps, is reported in our consolidated statement of operations and comprehensive income in gain (loss) on derivative instruments and other securities, net. Cash flows from interest rate swaps subsequent to our discontinuance of hedge accounting are classified in investing activities on our consolidated statements of cash flows.
For fiscal year 2011, subsequent to discontinuance of hedge accounting, we reclassified $53.6 million of net deferred losses from accumulated OCI into interest expense related to our de-designated interest rate swaps; whereas our total net periodic interest costs related to our de-designated interest rate swaps subsequent to discontinuance of hedge accounting was $82.8 million. The difference of $29.2 million and periodic interest rate costs related to interest rate swaps that we never placed in a hedge designation of $5.8 million (or $35.0 million combined) and other swap losses of $81.1 million are reported in our accompanying consolidated statement of operations and comprehensive income in gain (loss) on derivative instruments and other securities, net. In addition, for fiscal year 2011, we reported $53.6 million of other comprehensive income related to the reversal of deferred losses on de-designated interest rate swaps from accumulated OCI in our accompanying consolidated statement of operations and comprehensive income for the period subsequent to discontinuance of hedge accounting. As of December 31, 2011, the net deferred loss in accumulated OCI related to de-designated interest rate swaps was $690.8 million and the weighted average remaining contractual term was 3.2 years. The net deferred loss expected to be reclassified from OCI into interest expense over the next twelve months is $204.6 million.
Interest rate swap agreements
We use interest rate swaps to economically hedge the variable cash flows associated with short-term borrowings made under our repurchase agreement facilities. Under our interest rate swap agreements, we typically pay a fixed-rate and receive a floating rate based on one or three-month LIBOR with terms up to 10 years, which has the effect of modifying the repricing characteristics of our repurchase agreements and cash flows on such liabilities.
We estimate the fair value of interest rate swaps based on inputs from a third-party pricing model. The third-party pricing model incorporates such factors as the Treasury curve, LIBOR rates, and the pay rate on the interest rate swaps. We also incorporate both our own and our counterparties’ nonperformance risk in estimating the fair value of our interest rate swap and swaption agreements. In considering the effect of nonperformance risk, we consider the impact of netting and credit enhancements, such as collateral postings and guarantees, and have concluded that our own and our counterparty risk is not significant to the overall valuation of these agreements.
Interest rate swaptions
We purchase interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the performance of our investment portfolio (referred to as “convexity risk”). The interest rate swaptions provide us the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as an asset in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the swaption is reported in gain (loss) on derivative instruments and other securities, net in our consolidated statement of operations and comprehensive income. If a swaption expires unexercised, the loss on the swaption would be equal to the premium paid. If we sell or exercise a swaption, the realized