AGNC 10Q 9/30/12


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________________________________ 
FORM 10-Q
 __________________________________________________
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 001-34057
__________________________________________________ 
AMERICAN CAPITAL AGENCY CORP.
(Exact name of registrant as specified in its charter)
__________________________________________________
Delaware
 
26-1701984
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
2 Bethesda Metro Center, 14th Floor
Bethesda, Maryland 20814
(Address of principal executive offices)
(301) 968-9300
(Registrant’s telephone number, including area code)
 __________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter earlier period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
ý
 
Accelerated filer
¨
 
 
 
 
 
Non-accelerated filer
¨
(Do not check if a smaller reporting company)
Smaller Reporting Company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of October 31, 2012 was 341,598,550
 




AMERICAN CAPITAL AGENCY CORP.
TABLE OF CONTENTS
 
FINANCIAL INFORMATION
 
 
 
 
Financial Statements
Management's Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
 
 
 
OTHER INFORMATION
 
 
 
 
Legal Proceedings
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Other Information
Exhibits
 
 
 


1



PART I.-FINANCIAL INFORMATION

Item 1. Financial Statements

AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED BALANCE SHEETS
(in millions, except per share data)

 
 
 
September 30, 2012
 
December 31, 2011
 
(Unaudited)
 
 
Assets:
 
 
 
Agency securities, at fair value (including pledged securities of $83,600 and $50,667, respectively)
$
88,020

 
$
54,625

Agency securities transferred to consolidated variable interest entities, at fair value
1,620

 
58

U.S. Treasury securities, at fair value (pledged security)

 
101

Cash and cash equivalents
2,569

 
1,367

Restricted cash
369

 
336

Derivative assets, at fair value
292

 
82

Receivable for securities sold (including pledged securities of $1,466 and $319, respectively)
2,326

 
443

Receivable under reverse repurchase agreements
6,712

 
763

Other assets
269

 
197

Total assets
$
102,177

 
$
57,972

Liabilities:
 
 
 
Repurchase agreements
$
79,254

 
$
47,681

Debt of consolidated variable interest entities, at fair value
1,008

 
54

Payable for securities purchased
1,311

 
1,919

Derivative liabilities, at fair value
1,562

 
853

Dividends payable
430

 
314

Obligation to return securities borrowed under reverse repurchase agreements, at
fair value
7,265

 
899

Accounts payable and other accrued liabilities
74

 
40

Total liabilities
90,904

 
51,760

Stockholders’ equity:
 
 
 
8.000% Series A Cumulative Redeemable Preferred Stock; $0.01 par value; 6.9 and 0 shares issued and outstanding, respectively; liquidation preference of $25 per share ($173 and $0, respectively)
167

 

Common stock, $0.01 par value; 600.0 and 300.0 shares authorized; 341.6 and 224.1 shares issued and outstanding, respectively
3

 
2

Additional paid-in capital
9,536

 
5,937

Retained deficit
(672
)
 
(38
)
Accumulated other comprehensive income
2,239

 
311

Total stockholders’ equity
11,273

 
6,212

Total liabilities and stockholders’ equity
$
102,177

 
$
57,972


See accompanying notes to consolidated financial statements.


2



AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
(in millions, except per share data)

 
 
Three months ended September 30,
 
Nine months ended September 30,
 
2012
 
2011
 
2012
 
2011
Interest income:
 
 
 
 
 
 
 
Interest income
$
520

 
$
327

 
$
1,538

 
$
756

Interest expense
139

 
95

 
365

 
195

Net interest income
381

 
232

 
1,173

 
561

Other (loss) income, net:
 
 
 
 
 
 
 
Gain on sale of agency securities, net
210

 
263

 
843

 
361

Loss on derivative instruments and other securities, net
(460
)
 
(222
)
 
(1,442
)
 
(310
)
Total other (loss) income, net
(250
)
 
41

 
(599
)
 
51

Expenses:
 
 
 
 
 
 
 
Management fees
32

 
16

 
82

 
36

General and administrative expenses
8

 
6

 
22

 
13

Total expenses
40

 
22

 
104

 
49

Income before income tax provision
91

 
251

 
470

 
563

Income tax provision, net
5

 
1

 
4

 
1

Net income
86

 
250

 
466

 
562

Dividend on preferred stock
3

 

 
6

 

Net income available to common shareholders
$
83

 
$
250

 
$
460

 
$
562

 
 
 
 
 
 
 
 
Net income
$
86

 
$
250

 
$
466

 
$
562

Other comprehensive income:
 
 
 
 
 
 
 
Unrealized gain on available-for-sale securities, net
1,190

 
536

 
1,773

 
815

Unrealized gain (loss) on derivative instruments, net
51

 
(512
)
 
155

 
(704
)
Other comprehensive income
1,241

 
24

 
1,928

 
111

Comprehensive income
1,327

 
274

 
2,394

 
673

Dividend on preferred stock
3

 

 
6

 

Comprehensive income available to common shareholders
$
1,324

 
$
274

 
$
2,388

 
$
673

 
 
 
 
 
 
 
 
Weighted average number of common shares outstanding - basic and diluted
332.8

 
180.7

 
291.6

 
134.2

Net income per common share - basic and diluted
$
0.25

 
$
1.39

 
$
1.58

 
$
4.19

Comprehensive income per common share - basic and diluted
$
3.98

 
$
1.52

 
$
8.19

 
$
5.01

Dividends declared per common share
$
1.25

 
$
1.40

 
$
3.75

 
$
4.20

See accompanying notes to consolidated financial statements.


3



AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in millions)

 
Preferred Stock
 
Common Stock
 
Additional
Paid-in
Capital
 
Retained (Deficit)
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
 
Shares
 
Amount
 
Shares
 
Amount
 
Balance, December 31, 2011

 
$

 
224.1

 
$
2

 
$
5,937

 
$
(38
)
 
$
311

 
$
6,212

Net income

 

 

 

 

 
641

 

 
641

Other comprehensive (loss) income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized loss on available- for-sale securities, net

 

 

 

 

 

 
(106
)
 
(106
)
Unrealized gain on derivative instruments, net

 

 

 

 

 

 
52

 
52

Issuance of common stock

 

 
75.9

 
1

 
2,204

 

 

 
2,205

Common dividends declared

 

 

 

 

 
(286
)
 

 
(286
)
Balance, March 31, 2012 (Unaudited)

 

 
300.0

 
3

 
8,141

 
317

 
257

 
8,718

Net loss

 

 

 

 

 
(261
)
 

 
(261
)
Other comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized gain on available- for-sale securities, net

 

 

 

 

 

 
689

 
689

Unrealized gain on derivative instruments, net

 

 

 

 

 

 
52

 
52

Issuance of preferred stock
6.9

 
167

 

 

 

 

 

 
167

Issuance of common stock

 

 
4.8

 

 
155

 

 

 
155

Preferred dividends declared

 

 

 

 

 
(3
)
 

 
(3
)
Common dividends declared

 

 

 

 

 
(381
)
 

 
(381
)
Balance, June 30, 2012 (Unaudited)
6.9

 
167

 
304.8

 
3

 
8,296

 
(328
)
 
998

 
9,136

Net income

 

 

 

 

 
86

 

 
86

Other comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized gain on available- for-sale securities, net

 

 

 

 

 

 
1,190

 
1,190

Unrealized gain on derivative instruments, net

 

 

 

 

 

 
51

 
51

Issuance of common stock

 

 
36.8

 

 
1,240

 

 

 
1,240

Preferred dividends declared

 

 

 

 

 
(3
)
 

 
(3
)
Common dividends declared

 

 

 

 

 
(427
)
 

 
(427
)
Balance, September 30, 2012 (Unaudited)
6.9

 
$
167

 
341.6

 
$
3

 
$
9,536

 
$
(672
)
 
$
2,239

 
$
11,273

See accompanying notes to consolidated financial statements.


4



AMERICAN CAPITAL AGENCY CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in millions)
 
 
Nine months ended September 30,
 
2012
 
2011
Operating activities:
 
 
 
Net income
$
466

 
$
562

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Amortization of agency securities premiums and discounts, net
515

 
240

Amortization of accumulated other comprehensive loss on interest rate swaps de-designated as qualifying hedges
155

 

Gain on sale of agency securities, net
(843
)
 
(361
)
Loss on derivative instruments and other securities, net
1,442

 
310

Increase in other assets
(79
)
 
(91
)
Increase in accounts payable and other accrued liabilities
25

 
9

Accretion of discounts on debt of consolidated variable interest entities
2

 

Net cash provided by operating activities
1,683

 
669

Investing activities:
 
 
 
Purchases of agency securities
(86,435
)
 
(56,423
)
Proceeds from sale of agency securities
44,218

 
24,351

Principal collections on agency securities
6,906

 
3,058

Purchases of U.S. Treasury securities
(2,444
)
 
(4,059
)
Proceeds from sale of U.S. Treasury securities
2,545

 
3,791

Proceeds from short sales of U.S. Treasury securities
29,698

 
12,054

Purchases of U.S. Treasury securities to cover short sales
(23,450
)
 
(11,919
)
Proceeds from reverse repurchase agreements
50,715

 
28,615

Payments made on reverse repurchase agreements
(56,661
)
 
(28,842
)
Net payments on other derivative instruments not designated as qualifying hedges
(816
)
 
(194
)
Increase in restricted cash
(33
)
 
(298
)
Net cash used in investing activities
(35,757
)
 
(29,866
)
Financing activities:
 
 
 
Proceeds from repurchase arrangements
310,225

 
247,495

Payments made on repurchase agreements
(278,652
)
 
(220,333
)
Proceeds from debt of consolidated variable interest entities
1,000

 

Repayments on debt of consolidated variable interest entities
(80
)
 
(16
)
Net proceeds from preferred stock issuances
167

 


Net proceeds from common stock issuances
3,600

 
3,268

Cash dividends paid
(984
)
 
(406
)
Net cash provided by financing activities
35,276

 
30,008

Net change in cash and cash equivalents
1,202

 
811

Cash and cash equivalents at beginning of period
1,367

 
173

Cash and cash equivalents at end of period
$
2,569

 
$
984

See accompanying notes to consolidated financial statements.


5



AMERICAN CAPITAL AGENCY CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1. Unaudited Interim Consolidated Financial Statements
The interim consolidated financial statements of American Capital Agency Corp. (referred throughout this report as the “Company”, “we”, “us” and “our”) are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates.
Our unaudited consolidated financial statements include the accounts of our wholly-owned taxable REIT subsidiary, American Capital Agency TRS, LLC, and variable interest entities for which the Company is the primary beneficiary. Significant intercompany accounts and transactions have been eliminated. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, necessary for the fair presentation of financial statements for the interim period have been included. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year.

Note 2. Organization
We were organized in Delaware on January 7, 2008, and commenced operations on May 20, 2008 following the completion of our initial public offering (“IPO”). Our common stock is traded on The NASDAQ Global Select Market under the symbol “AGNC”.
We operate so as to qualify to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”). Therefore, substantially all of our assets, other than our taxable REIT subsidiary ("TRS"), consist of qualified real estate assets (as defined under the Internal Revenue Code). As a REIT, we are required to distribute annually 90% of our taxable net income. As long as we qualify as a REIT, we will generally not be subject to U.S. federal or state corporate taxes on our taxable net income to the extent that we distribute all of our annual taxable net income to our stockholders. It is our intention to distribute 100% of our taxable income, after application of available tax attributes, within the limits prescribed by the Internal Revenue Code, which may extend into the subsequent taxable year.
We are externally managed by American Capital AGNC Management, LLC (our “Manager”), an affiliate of American Capital, Ltd. (“American Capital”).
We earn income primarily from investing on a leveraged basis in agency mortgage-backed securities ("agency MBS"). These investments consist of residential mortgage pass-through securities and collateralized mortgage obligations (“CMOs”) for which the principal and interest payments are guaranteed by government-sponsored entities, such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as the Government National Mortgage Association (“Ginnie Mae”) (collectively referred to as “GSEs”). We may also invest in agency debenture securities issued by Freddie Mac, Fannie Mae or the Federal Home Loan Bank ("FHLB"). We refer to agency MBS and agency debenture securities collectively as "investment securities" and we refer to the specific investment securities in which we invest as our "investment portfolio".  
Our principal objective is to preserve our net asset value (also referred to as "net book value", "NAV" and "stockholders' equity") while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends from the combination of our net interest income and net realized gains and losses on our investments and hedging activities. We fund our investments primarily through short-term borrowings structured as repurchase agreements.

Note 3. Summary of Significant Accounting Policies
Investment Securities
ASC Topic 320, Investments—Debt and Equity Securities (“ASC 320”), requires that at the time of purchase, we designate a security as held-to-maturity, available-for-sale or trading, depending on our ability and intent to hold such security to maturity. Securities classified as trading and available-for-sale are reported at fair value, while securities classified as held-to-maturity are reported at amortized cost. We may, from time to time, sell any of our investment securities as part of our overall management of our investment portfolio. Accordingly, we typically designate our investment securities as available-for-sale. All securities classified as available-for-sale are reported at fair value, with unrealized gains and losses reported in other comprehensive income

6



("OCI") a separate component of stockholders’ equity. Upon the sale of a security, we determine the cost of the security and the amount of unrealized gains or losses to reclassify out of accumulated OCI into earnings based on the specific identification method.
Interest-only securities and inverse interest-only securities (collectively referred to as “interest-only securities”) represent our right to receive a specified proportion of the contractual interest flows of specific agency CMO securities. Principal-only securities represent our right to receive the contractual principal flows of specific agency CMO securities. Interest-only and principal-only securities are measured at fair value through earnings in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income. Our investments in interest-only and principal-only securities are included in agency MBS securities, at fair value on the accompanying consolidated balance sheets.
We estimate the fair value of our investment securities based on a market approach using Level 2 inputs from third-party pricing services and dealer quotes. The third-party pricing services use pricing models that incorporate such factors as coupons, primary and secondary mortgage rates, prepayment speeds, spread to the Treasury and interest rate swap curves, convexity, duration, periodic and life caps and credit enhancements. The dealer quotes incorporate common market pricing methods, including a spread measurement to the Treasury or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security. Refer to Note 7 for further discussion of fair value measurements.
We evaluate securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. The determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. When an investment security is impaired, an OTTI is considered to have occurred if (i) we intend to sell the investment security (i.e. a decision has been made as the reporting date) or (ii) it is more likely than not that we will be required to sell the investment security before recovery of its amortized cost basis. If we intend to sell the security or if it is more likely than not that we will be required to sell the investment security before recovery of its amortized cost basis, the entire amount of the impairment loss, if any, is recognized in earnings as a realized loss and the cost basis of the security is adjusted to its fair value.
We did not recognize any OTTI charges on any of our investment securities for the three and nine months ended September 30, 2012 and 2011.
Interest Income
Interest income is accrued based on the outstanding principal amount of the investment securities and their contractual terms. Premiums and discounts associated with the purchase of investment securities are amortized or accreted into interest income over the projected lives of the securities, including contractual payments and estimated prepayments using the interest method in accordance with ASC Subtopic 310-20, Receivables—Nonrefundable Fees and Other Costs (“ASC 310-20”).
We estimate long-term prepayment speeds of our agency securities using a third-party service and market data. The third-party service estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, current mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the reasonableness of the prepayment speeds estimated by the third-party service and, based on our Manager’s judgment, we may make adjustments to their estimates. Actual and anticipated prepayment experience is reviewed quarterly and effective yields are recalculated when differences arise between (i) our previously estimated future prepayments and (ii) actual prepayments to date plus current estimated future prepayments. If the actual and estimated future prepayment experience differs from our prior estimate of prepayments, we are required to record an adjustment in the current period to the amortization or accretion of premiums and discounts for the cumulative difference in the effective yield through the reporting date.
The yield on our adjustable rate securities further assumes that the securities reset at a rate equal to the underlying index rate in effect as of the date we acquired the security plus the stated margin.
Derivative and other Hedging Instruments
We use a variety of derivative instruments to economically hedge a portion of our exposure to market risks, including interest rate and prepayment risk. The objective of our risk management strategy is to reduce fluctuations in net book value over a range of interest rate scenarios. In particular, we attempt to mitigate the risk of the cost of our variable rate liabilities increasing during a period of rising interest rates. The principal instruments that we use are interest rate swaps and options to enter into interest rate swaps (“interest rate swaptions”). We also purchase or sell to-be-announced agency MBS forward contracts (“TBAs”), specified agency MBS on a forward basis, U.S. Treasury securities and U.S. Treasury futures contracts. We may also purchase or write put or call options on TBA securities and invest in other types of mortgage derivatives, such as interest-only securities, and synthetic

7



total return swaps, such as the Markit IOS Synthetic Total Return Swap Index (“Markit IOS Index”).
We account for derivative instruments in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”). ASC 815 requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value. Hedging instruments that are not derivatives under ASC 815 are accounted for as securities in accordance with ASC 320.
The accounting for changes in the fair value of derivative instruments depends on whether the instruments are designated and qualify as part of a hedging relationship pursuant to ASC 815.
Changes in fair value related to derivatives not in hedge designated relationships are recorded in gain (loss) on derivative instruments and other securities, net; whereas changes in fair value related to derivatives in hedge designated relationships are initially recorded in OCI and later reclassified to income at the time that the hedged transactions affect earnings. Any portion of the changes in fair value due to hedge ineffectiveness is immediately recognized in gain (loss) on derivative instruments and other securities, net.
Our derivative agreements and repurchase agreements generally contain provisions that allow for netting or setting off receivables and payables with each counterparty. We report amounts in our consolidated balance sheets on a gross basis without regard for such rights of offset or master netting arrangements.
Derivatives in a gain position are reported as derivative assets at fair value and derivatives in a loss position are reported as derivative liabilities at fair value in our consolidated balance sheets. In our consolidated statements of cash flows, cash receipts and payments related to derivative instruments are classified according to the underlying nature or purpose of the derivative transaction, generally in the operating section for derivatives designated in hedging relationships and the investing section for derivatives not designated in hedging relationships.
The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual 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. 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 and is being reclassified from accumulated OCI into interest expense on a straight-line basis over the remaining term of each interest rate swap. 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 comprehensive income in gain (loss) on derivative instruments and other securities, net.
Interest rate swap agreements
We use interest rate swaps to economically hedge the variable cash flows associated with 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 ("payer swap") 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 using a third-party pricing model. The third-party pricing model incorporates such factors as the LIBOR curve 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 swaps. 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.


8



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. Our swaption agreements typically provide us the option to enter into a pay fixed rate interest rate swap, which we refer as “payer swaptions”. We may also enter into swaption agreements that provide us the option to enter into a receive fixed interest rate swap, which we refer to as "receiver swaptions". 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 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 gain or loss on the swaption would be equal to the difference between the cash or the fair value of the underlying interest rate swap received and the premium paid.
We estimate the fair value of interest rate swaptions using a third-party pricing model based on the fair value of the future interest rate swap that we have the option to enter into as well as the remaining length of time that we have to exercise the option, adjusted for non-performance risk, if any.
TBA securities
A TBA security is a forward contract for the purchase ("long position") or sale ("short position") of agency MBS at a predetermined price, face amount, issuer, coupon and stated maturity on an agreed-upon future date. The specific agency MBS delivered into the contract upon the settlement date, published each month by the Securities Industry and Financial Markets Association, are not known at the time of the transaction. The difference between the contract price and the fair value of the TBA security is reported in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income. Upon settlement of the TBA contract, the realized gain or loss on the TBA contract is equal to the difference between the fair value of the underlying agency MBS physically received/delivered and the contract price, or if cash settled, is equal to the net cash amount paid or received.
We estimate the fair value of TBA securities based on similar methods used to value our agency MBS securities.
Forward commitments to purchase or sell specified agency MBS
We enter into forward commitments to purchase or sell specified agency MBS from time to time as a means of acquiring assets or as a hedge against short-term changes in interest rates. We account for contracts for the purchase or sale of specified agency MBS securities as derivatives if the delivery of the specified agency MBS and settlement extends beyond the shortest period possible for that type of security. Realized and unrealized gains and losses associated with forward commitments accounted for as derivatives are recognized in our consolidated statements of comprehensive income in gain (loss) on derivative instruments and other securities, net.
We estimate the fair value of forward commitments to purchase or sell specified agency MBS based on similar methods used to value agency MBS, as well as the remaining length of time of the forward commitment.
U.S. Treasury securities
We purchase or sell short U.S. Treasury securities and U.S. Treasury futures contracts to help mitigate the potential impact of changes in interest rates on the performance of our portfolio. We borrow securities to cover short sales of U.S. Treasury securities under reverse repurchase agreements. We account for these as securities borrowing transactions and recognize an obligation to return the borrowed securities at fair value on the balance sheet based on the value of the underlying borrowed securities as of the reporting date. Gains and losses associated with purchases and short sales of U.S. Treasury securities are recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
Total return swaps
We enter into total return swaps to obtain exposure to a security or market sector without owning such security or investing directly in that market sector. Total return swaps are agreements in which there is an exchange of cash flows whereby one party commits to make payments based on the total return (coupon plus the mark-to-market movement) of an underlying instrument or index in exchange for fixed or floating rate interest payments. To the extent the total return of the instrument or index underlying the transaction exceeds or falls short of the offsetting interest rate obligation, we will receive a payment from or make a payment to the counterparty.

9



The primary total return swap index in which we invest is the Markit IOS Index. Total return swaps based on the Markit IOS Index are intended to synthetically replicate the performance of interest-only securities. We determine the fair value of our total return swaps based on published index prices. Gains and losses associated with changes in market value of the underlying index and coupon interest are recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
Variable Interest Entities
ASC Topic 810, Consolidation (“ASC 810”), requires an enterprise to consolidate a variable interest entity ("VIE") if it is deemed the primary beneficiary of the VIE. Further, ASC 810 requires a qualitative assessment to determine the primary beneficiary of a VIE and ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as additional disclosures for entities that have variable interests in VIEs.
We have entered into transactions involving CMO trusts (e.g. a VIE) whereby, in each case, we transferred agency MBS to an investment bank in exchange for cash proceeds and at the same time entered into a commitment with the same investment bank to purchase to-be-issued securities collateralized by the agency MBS transferred, which resulted in our consolidation of the CMO trusts. We will consolidate a CMO trust if we are the CMO trust’s primary beneficiary; that is, if we have a variable interest that provides us with a controlling financial interest in the CMO trust. An entity is deemed to have a controlling financial interest if the entity has the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and the obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE. As part of the qualitative assessment in determining if we have a controlling financial interest, we evaluate whether we control the selection of financial assets transferred to the CMO trust.
Agency MBS transferred to consolidated VIEs are reported on our consolidated balance sheets in agency securities transferred to consolidated variable interest entities, at fair value and can only be used to settle the obligations of each respective VIE.
We report debt issued in connection with the CMO trusts on our consolidated balance sheets in debt of consolidated VIEs, at fair value, which represents tranches within the trusts sold to third-parties and excludes tranches acquired by us that eliminate in consolidation. The third-party beneficial interest holders in the VIEs have no recourse against our general credit. For transactions entered into subsequent to December 31, 2011, we have elected the option to account for the consolidated debt at fair value, with changes in fair value reflected in earnings during the period in which they occur. We believe this election more appropriately reflects our financial position as both the consolidated assets and consolidated debt are presented in a consistent manner on our consolidated balance sheets. We estimate the fair value of the consolidated debt based on a market approach using Level 2 inputs from third-party pricing services and dealer quotes.
Recent Accounting Pronouncements
In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities (“ASU 2011-11”). The update requires new disclosures about balance sheet offsetting and related arrangements. For derivatives and financial assets and liabilities, the amendments require disclosure of gross asset and liability amounts, amounts offset on the balance sheet, and amounts subject to the offsetting requirements but not offset on the balance sheet. The guidance is effective January 1, 2013 and is to be applied retrospectively. This guidance does not amend the existing guidance on when it is appropriate to offset. As a result, we do not expect this guidance to have a material effect on our financial statements.
Reclassifications
Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period presentation.

Note 4. Investment Securities

As of September 30, 2012, we had agency MBS at fair value of $89.6 billion, with a total cost basis of $86.9 billion. The net unamortized premium balance on our investment portfolio as of September 30, 2012 was $4.4 billion, including interest-only and principal-only strips. The following tables summarize our investments in agency MBS as of September 30, 2012 (dollars in millions):


10



 
September 30, 2012
Agency MBS
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Available-for-sale agency MBS:
 
 
 
 
 
 
 
Agency MBS, par
$
64,352

 
$
17,512

 
$
260

 
$
82,124

Unamortized premium
3,319

 
827

 
12

 
4,158

Amortized cost
67,671

 
18,339

 
272

 
86,282

Gross unrealized gains
2,161

 
617

 
6

 
2,784

Gross unrealized losses
(1
)
 

 

 
(1
)
Total available-for-sale agency MBS, at fair value
69,831

 
18,956

 
278

 
89,065

Agency MBS remeasured at fair value through earnings:
 
 
 
 
 
 
 
Interest-only and principal-only strips, amortized cost (1)
508

 
60

 

 
568

Gross unrealized gains
30

 
1

 

 
31

Gross unrealized losses
(12
)
 
(12
)
 

 
(24
)
Total agency MBS remeasured at fair value through earnings
526

 
49

 

 
575

Total agency MBS, at fair value
$
70,357

 
$
19,005

 
$
278

 
$
89,640

Weighted average coupon as of September 30, 2012 (2)
3.74
%
 
3.88
%
 
3.78
%
 
3.77
%
Weighted average yield as of September 30, 2012 (3)
2.56
%
 
2.82
%
 
1.60
%
 
2.61
%
Weighted average yield for the three months ended September 30, 2012 (3)
2.53
%
 
2.62
%
 
1.54
%
 
2.55
%
Weighted average yield for the nine months ended September 30, 2012 (3)
2.82
%
 
2.85
%
 
1.64
%
 
2.82
%
 ________________________
1.
Interest-only agency MBS strips represent the right to receive a specified portion of the contractual interest flows of the underlying unamortized principal balance (“UPB” or “par value”) of specific agency CMO securities. Principal-only agency MBS strips represent the right to receive contractual principal flows of the UPB of specific agency CMO securities. The UPB of our interest-only agency MBS strips was $1.8 billion and the weighted average contractual interest we are entitled to receive was 5.70% of this amount as of September 30, 2012. The par value of our principal-only agency MBS strips was $309 million as of September 30, 2012.
2.
The weighted average coupon includes the interest cash flows from our interest-only agency MBS strips taken together with the interest cash flows from our fixed-rate, adjustable-rate and CMO agency MBS as a percentage of the par value of our agency MBS (excluding the UPB of our interest-only securities) as of September 30, 2012.
3.
Incorporates a weighted average future constant prepayment rate assumption of 14% based on forward rates as of September 30, 2012 and a weighted average reset rate for adjustable rate securities of 2.67%, which is equal to a weighted average underlying index rate of 0.96% based on the current spot rate in effect as of the date we acquired the securities and a weighted average margin of 1.71%.

 
September 30, 2012
Agency MBS
Amortized
Cost
 
Gross
Unrealized
Gain
 
Gross
Unrealized
Loss
 
Fair Value
Fixed-Rate
$
85,136

 
$
2,747

 
$
(1
)
 
$
87,882

Adjustable-Rate
960

 
32

 

 
992

CMO
186

 
5

 

 
191

Interest-only and principal-only strips
568

 
31

 
(24
)
 
575

Total agency MBS
$
86,850

 
$
2,815

 
$
(25
)
 
$
89,640


As of December 31, 2011, we had agency MBS at fair value of $54.7 billion, with a total cost basis of $53.7 billion. The net unamortized premium balance on our investment portfolio as of December 31, 2011 was $2.4 billion, including interest-only and principal-only strips. The following tables summarize our investments in agency MBS as of December 31, 2011 (dollars in millions): 


11



 
December 31, 2011
Agency MBS
Fannie Mae
 
Freddie Mac
 
Ginnie Mae
 
Total
Available-for-sale agency MBS:
 
 
 
 
 
 
 
Agency MBS, par
$
37,232

 
$
13,736

 
$
258

 
$
51,226

Unamortized premium
1,659

 
606

 
12

 
2,277

Amortized cost
38,891

 
14,342

 
270

 
53,503

Gross unrealized gains
680

 
324

 
3

 
1,007

Gross unrealized losses
(4
)
 
(2
)
 

 
(6
)
Available-for-sale agency MBS, at fair value
39,567

 
14,664

 
273

 
54,504

Agency MBS remeasured at fair value through earnings:
 
 
 
 
 
 
 
Interest-only and principal-only strips, amortized cost (1)
124

 
67

 

 
191

Gross unrealized gains
6

 
3

 

 
9

Gross unrealized losses
(8
)
 
(13
)
 

 
(21
)
Agency MBS remeasured at fair value through earnings
122

 
57

 

 
179

Total agency MBS, at fair value
$
39,689

 
$
14,721

 
$
273

 
$
54,683

Weighted average coupon as of December 31, 2011 (2)
4.18
%
 
4.39
%
 
3.74
%
 
4.23
%
Weighted average yield as of December 31, 2011 (3)
3.03
%
 
3.20
%
 
1.71
%
 
3.07
%
Weighted average yield for the year ended December 31, 2011 (3)
3.19
%
 
3.20
%
 
2.05
%
 
3.19
%
 ________________________
1.
The UPB of our interest-only securities was $1.1 billion and the weighted average contractual interest we are entitled to receive was 5.52% of this amount as of December 31, 2011. The par value of our principal-only agency MBS strips was $40 million as of December 31, 2011.
2.
The weighted average coupon includes the interest cash flows from our interest-only securities taken together with the interest cash flows from our fixed-rate, adjustable-rate and CMO securities as a percentage of the par value of our agency securities (excluding the UPB of our interest-only securities) as of December 31, 2011.
3.
Incorporates a weighted average future constant prepayment rate assumption of 14% based on forward rates as of December 31, 2011 and a weighted average reset rate for adjustable rate securities of 2.71%, which is equal to a weighted average underlying index rate of 0.94% based on the current spot rate in effect as of the date we acquired the securities and a weighted average margin of 1.77%.

 
December 31, 2011
Agency MBS
Amortized
Cost
 
Gross
Unrealized
Gain
 
Gross
Unrealized
Loss
 
Fair Value
Fixed-Rate
$
50,535

 
$
952

 
$
(4
)
 
$
51,483

Adjustable-Rate
2,725

 
51

 
(2
)
 
2,774

CMO
243

 
4

 

 
247

Interest-only strips
191

 
9

 
(21
)
 
179

Total agency MBS
$
53,694

 
$
1,016

 
$
(27
)
 
$
54,683


As of September 30, 2012 and December 31, 2011, we did not have investments in agency debenture securities.

The actual maturities of our agency MBS securities are generally shorter than the stated contractual maturities. Actual maturities are affected by the contractual lives of the underlying mortgages, periodic contractual principal payments and principal prepayments. As of September 30, 2012 and December 31, 2011, our weighted average expected constant prepayment rate (“CPR”) over the remaining life of our aggregate agency MBS portfolio was 14%. Our estimates differ materially for different types of securities and thus individual holdings have a wide range of projected CPRs. We estimate long-term prepayment assumptions for different securities using a third-party service and market data. The third-party service estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate reasonableness. As market conditions may change rapidly, we may make adjustments for different securities based on our Manager's judgement. Various market participants could use materially different assumptions.

The following table summarizes our agency MBS classified as available-for-sale as of September 30, 2012 and December 31, 2011 according to their estimated weighted average life classification (dollars in millions):

12




 
 
September 30, 2012
 
December 31, 2011
Estimated Weighted Average Life of Agency MBS Classified as Available-for-Sale
 
Fair Value
 
Amortized
Cost
 
Weighted
Average
Coupon
 
Fair Value
 
Amortized
Cost
 
Weighted
Average
Coupon
Less than or equal to 1 year
 
$

 
$

 
%
 
$
214

 
$
210

 
4.61
%
Greater than 1 year and less than/equal to 3 years
 
9,902

 
9,656

 
3.17
%
 
3,392

 
3,338

 
4.38
%
Greater than 3 years and less than/equal to 5 years
 
39,737

 
38,442

 
3.66
%
 
26,168

 
25,616

 
3.99
%
Greater than 5 years and less than/equal to 10 years
 
38,832

 
37,600

 
3.80
%
 
24,710

 
24,320

 
4.19
%
Greater than 10 years
 
594

 
584

 
3.55
%
 
20

 
19

 
5.02
%
Total
 
$
89,065

 
$
86,282

 
3.66
%
 
$
54,504

 
$
53,503

 
4.11
%

The weighted average life of our interest-only agency MBS strips was 4.8 and 3.0 years as of September 30, 2012 and December 31, 2011, respectively. The weighted average life of our principal-only agency MBS strips was 5.6 and 2.6 years as of September 30, 2012 and December 31, 2011, respectively.

Our agency securities classified as available-for-sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported in OCI, a component of stockholders’ equity. The following table summarizes changes in accumulated OCI for our available-for-sale securities for the three and nine months ended September 30, 2012 and 2011 (in millions): 

Agency Securities Classified as
Available-for-Sale
 
Beginning OCI
Balance
 
Unrealized Gains
and (Losses), Net
 
Reversal of Prior
Period Unrealized
(Gains) and Losses,
Net on Realization
 
Ending OCI
Balance
Three months ended September 30, 2012
 
$
1,585

 
1,400

 
(210
)
 
$
2,775

Three months ended September 30, 2011
 
$
251

 
802

 
(266
)
 
$
787

Nine months ended September 30, 2012
 
$
1,002

 
2,616

 
(843
)
 
$
2,775

Nine months ended September 30, 2011
 
$
(28
)
 
1,178

 
(363
)
 
$
787


The following table presents the gross unrealized loss and fair values of our available-for-sale agency securities by length of time that such securities have been in a continuous unrealized loss position as of September 30, 2012 and December 31, 2011 (in millions):

 
 
Unrealized Loss Position For
 
 
Less than 12 Months
 
12 Months or More
 
Total
Agency Securities Classified as
Available-for-Sale
 
Estimated Fair
Value
 
Unrealized
Loss
 
Estimated
Fair Value
 
Unrealized
Loss
 
Estimated Fair
Value
 
Unrealized
Loss
September 30, 2012
 
$
436

 
$
(1
)
 
$

 
$

 
$
436

 
$
(1
)
December 31, 2011
 
$
1,135

 
$
(6
)
 
$

 
$

 
$
1,135

 
$
(6
)

As of September 30, 2012, we did not intend to sell any of these agency securities and we do not believe it is more likely than not we will be required to sell the agency securities before recovery of their amortized cost basis. The unrealized losses on these agency securities are not due to credit losses given the government-sponsored entity or government guarantees, but are rather due to changes in interest rates and prepayment expectations.
Gains and Losses
The following table is a summary of our net gain from the sale of agency MBS for the three and nine months ended September 30, 2012 and 2011 (in millions): 

13



 
Three Months Ended
 
Nine Months Ended
 Agency MBS
September 30, 2012
 
September 30, 2011
 
September 30, 2012
 
September 30, 2011
Agency MBS sold, at cost
$
(10,172
)
 
$
(14,046
)
 
$
(45,258
)
 
$
(26,429
)
Proceeds from agency MBS sold (1)
10,382

 
14,309

 
46,101

 
26,790

Net gains on sale of agency MBS
$
210

 
$
263

 
$
843

 
$
361

 
 
 
 
 
 
 
 
Gross gains on sale of agency MBS
$
210

 
$
268

 
$
855

 
$
377

Gross losses on sale of agency MBS

 
(5
)
 
(12
)
 
(16
)
Net gains on sale of agency MBS
$
210

 
$
263

 
$
843

 
$
361

  ________________________
1.
Proceeds include cash received during the period, plus receivable for agency MBS sold during the period as of period end.

For the three and nine months ended September 30, 2012, we recognized an unrealized gain of $20 million and $19 million, respectively, and for the three and nine months ended September 30, 2011, we recognized an unrealized gain of $28 million and $24 million, respectively, in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income for the change in value of investments in interest-only and principal-only agency MBS strips, net of prior period reversals. For the three and nine months ended September 30, 2012, we recognized no realized gain or loss, and for the three and nine months ended September 30, 2011, we recognized a realized loss of $3 million in gain on sale of agency securities, net, in our consolidated statements of operations and comprehensive income for the sales of interest-only and principal-only securities.
Pledged Assets
The following tables summarize our assets pledged as collateral under repurchase agreements, debt of consolidated VIEs, derivative agreements and prime broker agreements by type, including securities pledged related to securities sold but not yet settled, as of September 30, 2012 and December 31, 2011 (in millions):
 
 
September 30, 2012
Assets Pledged
 
Repurchase Agreements
 
Debt of Consolidated VIEs
 
Derivative Agreements
 
Prime Broker Agreements
 
Total
Agency MBS - fair value
 
$
83,654

 
$
1,620

 
$
1,255

 
$
157

 
$
86,686

Accrued interest on pledged securities
 
234

 
5

 
4

 

 
243

Restricted cash
 

 

 
369

 

 
369

Total
 
$
83,888

 
$
1,625

 
$
1,628

 
$
157

 
$
87,298

 
 
 
December 31, 2011
Assets Pledged
 
Repurchase Agreements
 
Debt of Consolidated VIEs
 
Derivative Agreements
 
Prime Broker Agreements
 
Total
Agency MBS - fair value
 
$
50,255

 
$
58

 
$
644

 
$
87

 
$
51,044

U.S. Treasury securities - fair value
 
101

 

 

 

 
101

Accrued interest on pledged securities
 
161

 

 
2

 

 
163

Restricted cash
 

 

 
336
 

 
336

Total
 
$
50,517

 
$
58

 
$
982

 
$
87

 
$
51,644


The following table summarizes our securities pledged as collateral under repurchase agreements and debt of consolidated VIEs by remaining maturity, including securities pledged related to sold but not yet settled securities, as of September 30, 2012 and December 31, 2011 (dollars in millions):

14



 
 
September 30, 2012
 
December 31, 2011
Securities Pledged by Remaining Maturity of Repurchase Agreements and Debt of Consolidated VIEs
 
Fair Value of Pledged Securities
 
Amortized
Cost of Pledged Securities
 
Accrued
Interest on
Pledged
Securities
 
Fair Value of Pledged Securities
 
Amortized
Cost of Pledged Securities
 
Accrued
Interest on
Pledged
Securities
Agency MBS:
 
 
 
 
 
 
 
 
 
 
 
 
  Less than 30 days
 
$
30,861

 
$
29,867

 
$
86

 
$
19,772

 
$
19,361

 
$
63

  31 - 59 days
 
17,739

 
17,134

 
51

 
16,964

 
16,648

 
55

  60 - 90 days
 
17,822

 
17,242

 
50

 
8,337

 
8,179

 
26

  Greater than 90 days
 
18,852

 
18,348

 
52

 
5,240

 
5,154

 
17

Total agency MBS
 
85,274

 
82,591

 
239

 
50,313

 
49,342

 
161

U.S. Treasury securities:
 
 
 
 
 
 
 
 
 
 
 
 
  1 day
 

 

 

 
101

 
101

 

Total securities
 
$
85,274

 
$
82,591

 
$
239

 
$
50,414

 
$
49,443

 
$
161

As of September 30, 2012 and December 31, 2011, none of our repurchase agreement borrowings backed by agency MBS were due on demand or mature overnight.
Securitizations
All of our CMO securities are backed by fixed or adjustable-rate agency MBS. Fannie Mae or Freddie Mac guarantees the payment of interest and principal and acts as the trustee and administrator of their respective securitization trusts. Accordingly, we are not required to provide the beneficial interest holders of the CMO securities any financial or other support. Our maximum exposure to loss related to our involvement with CMO trusts is the fair value of the CMO securities and interest-only and principal-only securities held by us, less principal amounts guaranteed by Fannie Mae and Freddie Mac.
As of September 30, 2012 and December 31, 2011, the fair value of all of our CMO securities, interest-only securities and principal-only securities, excluding the consolidated CMO trusts discussed below, was $766 million and $426 million, respectively, or $1.4 billion and $429 million, respectively, including the net asset value of the consolidated CMO trusts discussed below. Our maximum exposure to loss related to our CMO securities and interest-only and principal-only securities, including the consolidated CMO trust, was $375 million and $155 million as of September 30, 2012 and December 31, 2011, respectively.
We have consolidated CMO trusts for which we have determined we are the primary beneficiary of the trusts. In connection with the consolidated trusts, as of September 30, 2012 and December 31, 2011, we recognized agency securities with a total fair value of $1.6 billion and $58 million, respectively, and a principal balance of $1.5 billion and $55 million, respectively, and debt with a carrying value of $1.0 billion and $54 million, respectively, in our accompanying consolidated balance sheets. The total fair value of debt for which we have elected the option to account for at fair value was $968 million as of September 30, 2012, with a principal balance $939 million (or $936 million, net of discounts). For the three and nine months ended September 30, 2012, we recognized an unrealized loss of $24 million and $32 million in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income for the change in value of debt of our consolidated VIEs. Our involvement with the consolidated trusts is limited to the agency securities transferred to the trusts and the CMO securities subsequently held by us. There are no arrangements that could require us to provide financial support to the trusts.

Note 5. Repurchase Agreements and Other Debt
We pledge certain of our agency securities as collateral under repurchase arrangements with financial institutions, the terms and conditions of which are negotiated on a transaction-by-transaction basis. Interest rates on these borrowings are generally based on LIBOR plus or minus a margin and amounts available to be borrowed are dependent upon the fair value of the securities pledged as collateral, which fluctuates with changes in interest rates, type of security and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in fair value of pledged securities, lenders may require us to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. As of September 30, 2012 and December 31, 2011, we have met all margin call requirements.
The following table summarizes our borrowings under repurchase arrangements and weighted average interest rates classified by original maturities as of September 30, 2012 and December 31, 2011 (dollars in millions):

15



 
 
September 30, 2012
 
December 31, 2011
Original Maturity
 
Repurchase Agreements
 
Weighted
Average
Interest
Rate
 
Weighted
Average Days
to Maturity
 
Repurchase Agreements
 
Weighted
Average
Interest
Rate
 
Weighted
Average Days
to Maturity
Agency MBS:
 
 
 
 
 
 
 
 
 
 
 
 
1 month or less
 
$
4,724

 
0.43
%
 
12

 
$
2,558

 
0.43
%
 
10

1-3 months
 
31,253

 
0.43
%
 
37

 
24,518

 
0.39
%
 
32

4-6 months
 
25,571

 
0.45
%
 
72

 
16,475

 
0.37
%
 
53

7-9 months
 
8,641

 
0.49
%
 
92

 
2,423

 
0.45
%
 
141

10-12 months
 
7,547

 
0.57
%
 
266

 
1,006

 
0.53
%
 
244

13-24 months
 
693

 
0.67
%
 
613

 
600

 
0.51
%
 
268

25-36 months
 
825

 
0.72
%
 
992

 

 

 

Total agency MBS
 
79,254

 
0.46
%
 
89

 
47,580

 
0.40
%
 
51

U.S. Treasury securities:
 
 
 
 
 
 
 
 
 
 
 
 
1 day
 

 

 

 
101

 
0.40
%
 
1

Total / Weighted Average
 
$
79,254

 
0.46
%
 
89

 
$
47,681

 
0.40
%
 
51

As of September 30, 2012 and December 31, 2011, we did not have an amount at risk with any repurchase agreement counterparty greater than 4% of our stockholders’ equity.
As of September 30, 2012 and December 31, 2011, we had other debt consisting of debt of consolidated VIEs outstanding with a carrying value of $1.0 billion and $54 million, respectively, and a principal balance of $979 million (or $976 million, net of original issue discounts) and $54 million, respectively. Debt of consolidated VIEs consists of variable rate debt outstanding in connection with the consolidation of structured transactions for which we are the primary beneficiary of in our accompanying financial statements. As of September 30, 2012, debt of consolidated VIEs carried a weighted average interest rate of LIBOR plus 42 basis points. The actual maturities of debt of consolidated VIEs are generally shorter than the stated contractual maturities. The actual maturities are affected by the contractual lives of the underlying agency MBS securitizing the debt of consolidated VIEs and periodic principal prepayments of such underlying securities. The estimated weighted average life of debt of consolidated VIEs as of September 30, 2012 was 3.8 years.

Note 6. Derivative and Other Hedging Instruments
In connection with our risk management strategy, we hedge a portion of our interest rate risk by entering into derivative and other hedging instrument contracts. We may enter into agreements for interest rate swaps, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts. We may also purchase or short TBA and U.S. Treasury securities, purchase or write put or call options on TBA securities or we may invest in other types of mortgage derivative securities, such as interest-only securities, and synthetic total return swaps, such as the Markit IOS Index. Our risk management strategy attempts to manage the overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to stockholders. For additional information regarding our derivative instruments and our overall risk management strategy, please refer to the discussion of derivative and other hedging instruments in Note 3.
As of September 30, 2012 and December 31, 2011, our derivative and other hedging instruments were comprised primarily of interest rate swaps, which have the effect of economically modifying the repricing characteristics of our repurchase agreements and cash flows on such liabilities. Our interest rate swaps are used to manage the interest rate risk created by our variable rate short-term repurchase agreements. Under our interest rate swaps, we typically pay a fixed-rate and receive a floating rate based on one-month LIBOR with terms up to 10 years.
Derivative and other hedging instruments entered into in addition to interest rate swap agreements are intended to supplement our use of interest rate swaps and we do not currently expect our use of these instruments to be the primary protection against interest rate risk for our portfolio. These instruments are accounted for as derivatives, but are not generally designated as hedges under ASC 815, or as other securities, with any changes in the fair values of the contracts prior to their settlement date included in earnings in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income. We do not use derivative or other hedging instruments for speculative purposes.


16



Derivatives Designated as Hedging Instruments
Prior to September 30, 2011, our interest rate swaps were typically designated as cash flow hedges 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 further information regarding our discontinuation of hedge accounting please refer to Note 3.
For the three and nine months ended September 30, 2012, we reclassified $51 million and $155 million, respectively, of net deferred losses from accumulated OCI into interest expense related to our de-designated interest rate swaps and recognized an equal, but offsetting, amount in other comprehensive income. Our total net periodic interest costs on our swap portfolio was $125 million and $330 million for the three and nine months ended September 30, 2012, respectively. The difference of $74 million and $175 million for the three and nine months ended September 30, 2012, respectively, are reported in our accompanying consolidated statement of comprehensive income in gain (loss) on derivative instruments and other securities, net. As of September 30, 2012, the net deferred loss in accumulated OCI related to de-designated interest rate swaps was $536 million and the weighted average remaining contractual term was 2.5 years. The net deferred loss expected to be reclassified from OCI into interest expense over the next twelve months is $194 million.
The following tables summarize information about our outstanding interest rate swaps designated as hedging instruments under ASC 815 and their effect on our consolidated statement of comprehensive income for the three and nine months ended September 30, 2011 (dollars in millions).
Interest Rate Swaps Designated
as Hedging Instruments
Beginning
Notional Amount
 
Additions
 
Expirations / Terminations
 
Hedge De-Designations
 
Ending
Notional  Amount
Three months ended September 30, 2011
$
22,000

 
2,100

 
(200
)
 
(23,900
)
 
$

Nine months ended September 30, 2011
$
6,450

 
17,900

 
(450
)
 
(23,900
)
 
$

Interest Rate Swaps Designated as Hedging Instruments:
 
Amount of
Gain or (Loss)
Recognized in
OCI
(Effective
Portion)
 
Location of Gain
or (Loss)
Reclassified from
OCI into
Earnings (Effective
Portion)
 
Amount of (Gain) or
Loss Reclassified
from OCI into
Earnings
(Effective Portion)
 
Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)
 
Amount of Gain
or (Loss)
Recognized in
Earnings
(Ineffective
Portion and
Amount
Excluded from
Effectiveness
Testing)
Three Months Ended September 30, 2011
 
$
(512
)
 
Interest expense
 
(71
)
 
Gain (loss) on derivative instruments and other securities, net
 
$
(1
)
Nine Months Ended September 30, 2011
 
$
(707
)
 
Interest expense
 
(140
)
 
Gain (loss) on derivative instruments and other securities, net
 
$
(2
)
During the nine months ended September 30, 2011, we also held forward contracts to purchase TBA and specified agency securities that were designated as cash flow hedges pursuant to ASC 815. The following tables summarize information about these securities and their effect on our consolidated statement of comprehensive income for the nine months ended September 30, 2011 (dollars in millions). We did not designate any such agreements as cash flow hedges during the three months ended September 30, 2011 and the three and nine months ended September 30, 2012.
Purchases of TBAs and Forward
Settling Agency Securities
Designated as Hedging Instruments
Beginning
Notional Amount
 
Additions
 
Settlement /
Expirations
 
Ending
Notional  Amount
 
Fair Value
as of
Period End
 
Average
Maturity
as of
Period End
(Months)
Nine Months Ended September 30, 2011
$
245

 
$

 
$
(245
)
 
$

 
$

 


17



Purchases of TBAs and Forward
Settling Agency Securities
Designated as Hedging Instruments
 
Amount of Gain or (Loss)  Recognized
in OCI for Cash
Flow Hedges
(Effective Portion)
 
Amount of (Gain) or
Loss Recognized in
OCI for Cash Flow
Hedges and
Reclassified to OCI for
Available-for-Sale
Securities
(Effective Portion)
 
Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and Amount Excluded from Effectiveness Testing)
 
Amount of Gain or
(Loss) Recognized
in Earnings
(Ineffective Portion
and Amount
Excluded from
Effectiveness
Testing)
Nine months ended September 30, 2011
 
$

 
$
(3
)
 
Gain (loss) on derivative instruments and other
securities, net
 
$

Derivatives Not Designated as Hedging Instruments
The table below summarizes fair value information about our derivatives outstanding that were not designated as hedging instruments as of September 30, 2012 and December 31, 2011 (in millions).
Derivatives Not Designated as Hedging Instruments
Balance Sheet Location
 
September 30, 2012
 
December 31, 2011
Interest rate swaps
Derivative assets, at fair value
 
$
6

 
$
13

Payer swaptions
Derivative assets, at fair value
 
57

 
11

Purchase of TBA and forward settling agency securities
Derivative assets, at fair value
 
186

 
54

Sale of TBA and forward settling agency securities
Derivative assets, at fair value
 
43

 
3

Markit IOS total return swaps - long
Derivative assets, at fair value
 

 
1

 
 
 
$
292

 
$
82

Interest rate swaps
Derivative liabilities, at fair value
 
$
(1,442
)
 
$
(795
)
U.S. Treasury futures - short
Derivative liabilities, at fair value
 

 
(14
)
Purchase of TBA and forward settling agency securities
Derivative liabilities, at fair value
 
(20
)
 

Sale of TBA and forward settling agency securities
Derivative liabilities, at fair value
 
(100
)
 
(44
)
 
 
 
$
(1,562
)
 
$
(853
)
  Additionally, as of September 30, 2012 and December 31, 2011, we had obligations to return U.S. Treasury securities borrowed under reverse repurchase agreements accounted for as securities borrowing transactions at a fair value of $7.3 billion and $899 million, respectively. The borrowed securities were used to cover short sales of U.S. Treasury securities from which we received total proceeds of $7.2 billion and $880 million, respectively. The change in fair value of the borrowed securities is recorded in gain (loss) on derivative instruments and other securities, net in our consolidated statements of comprehensive income.
The tables below summarize the effect of derivative instruments not designated as hedges under ASC 815 on our consolidated statements of comprehensive income for the three and nine months ended September 30, 2012 and 2011 (in millions):

 
 
Three Months Ended September 30, 2012
Derivatives Not Designated as
Hedging Instruments
 
Notional
Amount
as of
June 30, 2012
 
Additions
 
Settlement, Termination,
Expiration or
Exercise
 
Notional
Amount
as of
September 30, 2012
 
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
Purchase of TBA and forward settling agency securities
 
$
7,447

 
36,956

 
(26,234
)
 
$
18,169

 
$
222

Sale of TBA and forward settling agency securities
 
$
10,851

 
53,318

 
(49,774
)
 
$
14,395

 
(173
)
Interest rate swaps
 
$
48,550

 
3,450

 
(3,150
)
 
$
48,850

 
(438
)
Payer swaptions
 
$
8,800

 
2,000

 
(2,250
)
 
$
8,550

 
(25
)
Short sales of U.S. Treasury securities
 
$
1,250

 
11,550

 
(5,505
)
 
$
7,295

 
(15
)
U.S. Treasury futures - short
 
$
1,919

 

 
(1,919
)
 
$

 
(27
)
Markit IOS total return swaps - long
 
$
37

 

 
(37
)
 
$

 

Markit IOS total return swaps - short
 
$
181

 

 
(181
)
 
$

 

 
 
 
 
 
 
 
 
 
 
$
(456
)
  ________________________________
1.
Excludes a gain of $20 million from interest-only and principal-only securities and a loss of $24 million from debt of consolidated VIEs re-measured

18



at fair value through earnings recognized in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income for the three months ended September 30, 2012.


 
 
Three Months Ended September 30, 2011
Derivatives Not Designated as
Hedging Instruments
 
Notional
Amount
as of
June 30, 2011
 
Additions
 
Additions Due to Hedge De-Designations
 
Settlement, Termination,
Expiration or
Exercise
 
Notional
Amount
as of
September 30, 2011
 
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
Purchase of TBA and forward settling agency securities
 
$
3,432

 
19,881

 

 
(17,877
)
 
$
5,436

 
$
73

Sale of TBA and forward settling agency securities
 
$
4,282

 
37,867

 

 
(35,895
)
 
$
6,254

 
(146
)
Interest rate swaps
 
$
150

 
2,900

 
23,900

 

 
$
26,950

 
(3
)
Payer swaptions
 
$
4,050

 
250

 

 
(1,050
)
 
$
3,250

 
(33
)
Short sales of U.S. Treasury securities
 
$
1,464

 
3,450

 

 
(4,449
)
 
$
465

 
(92
)
US Treasury futures - long
 
$

 
350

 

 

 
$
350

 
2

Markit IOS total return swaps - long
 
$
683

 
65

 

 
(683
)
 
$
65

 
(19
)
Markit IOS total return swaps - short
 
$
309

 
323

 

 
(309
)
 
$
323

 
20

 
 
 
 
 
 
 
 
 
 
 
 
$
(198
)
  ______________________
1.
Excludes a loss of $28 million from interest-only and principal-only securities re-measured at fair value through earnings, a loss of $1 million for hedge ineffectiveness on our outstanding interest rate swaps and a gain of $5 million from U.S. Treasury securities in gain (loss) on derivative instruments and other securities, net in our consolidated statement of comprehensive income for the three months ended September 30, 2011.

 
 
Nine Months Ended September 30, 2012
Derivatives Not Designated as
Hedging Instruments
 
Notional
Amount
as of December 31, 2011
 
Additions
 
Settlement,
Expiration or
Exercise
 
Notional
Amount
as of
September 30, 2012
 
Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
Purchase of TBA and forward settling agency securities
 
$
3,699

 
90,498

 
(76,028
)
 
$
18,169

 
$
343

Sale of TBA and forward settling agency securities
 
$
3,803

 
131,030

 
(120,438
)
 
$
14,395

 
(402
)
Interest rate swaps
 
$
30,250

 
23,300

 
(4,700
)
 
$
48,850

 
(1,067
)
Payer swaptions
 
$
3,200

 
12,150

 
(6,800
)
 
$
8,550

 
(96
)
Short sales of U.S. Treasury securities
 
$
880

 
30,480

 
(24,065