Note 8—Fair Value

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Assets and liabilities recorded at fair value on a recurring basis are presented in the first table below in this Note. From time to time, we may be required to measure at fair value other assets on a nonrecurring basis such as certain loans held for investment or investments in partnerships. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets.

Fair Value Hierarchy

The Company measures the fair value of its assets and liabilities based upon their contractual terms and using relevant market information. A description of the methods used by the Company to measure fair value is provided below. Fair value measurements are subjective in nature, involve uncertainties and often require the Company to make significant judgments. Changes in assumptions could significantly affect the Company’s measurement of fair value.

GAAP establishes a three-level hierarchy that prioritizes inputs into the valuation techniques used to measure fair value. Fair value measurements associated with assets and liabilities are categorized into one of the following levels of the hierarchy based upon how observable the valuation inputs are that are used in such measurements.

Level 1: Valuation is based upon quoted prices in active markets for identical instruments.

Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which significant inputs or significant value drivers are observable in active markets.

Level 3: Valuation is generated from techniques that use significant assumptions that are not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.

Recurring Changes in Fair Value

The following tables present the carrying amounts of assets and liabilities that are measured at fair value on a recurring basis by instrument type and based upon the level of the fair value hierarchy within which fair value measurements of such assets and liabilities are categorized:


	At
	September 30,		Fair Value Measurements
(in thousands)	2019		Level 1		Level 2		Level 3
Assets:
Investments in debt securities	$	34,121	$	─	$	─	$	34,121
Derivative instruments		574		─		574		─

Liabilities:
Derivative instruments	$	324	$	─	$	324	$	─


	At
	December 31,		Fair Value Measurements
(in thousands)	2018		Level 1		Level 2		Level 3
Assets:
Investments in debt securities	$	97,190	$	─	$	─	$	97,190
Derivative instruments		5,797		─		4,667		1,130

Changes in Fair Value Levels

We monitor the availability of observable market data to assess the appropriate classification of financial instruments within the fair value hierarchy and transfer between Level 1, Level 2, and Level 3 accordingly. Observable market data includes, but is not limited to, quoted prices and market transactions. Changes in economic conditions or market liquidity generally will drive changes in availability of observable market data. Changes in availability of observable market data, which also may result in changing the valuation technique used, are generally the cause of transfers between Level 1, Level 2 and Level 3.

For the three months ended September 30, 2019, and September 30, 2018, there were no individually significant transfers between Levels 1 and 2, or between Levels 2 and 3.

Changes in the fair value of assets and liabilities that are measured at fair value on a recurring basis and that are categorized as Level 3 within the fair value hierarchy are attributed in the following table to identified activities that occurred during the three months ended September 30, 2019:


	Investments in
(in thousands)	Debt Securities
Balance, July 1, 2019	$	35,236
Net change in AOCI (1)		(890)
Impact from sales or redemptions		(264)
Impact from settlements (2)		39
Balance, September 30, 2019	$	34,121

⁽¹⁾

This amount includes the reclassification into the Consolidated Statements of Operations of $1.9 million of net fair value gains related to bonds that were sold or redeemed during this reporting period. This decline was partially offset by $1.0 million of net unrealized gains recognized during this reporting period in connection with the Company’s bond investments.

⁽²⁾

This impact considers the effect of principal payments received and amortization of cost basis adjustments.

The following table provides information about the amount of realized and unrealized gains that were reported in the Company’s Consolidated Statements of Operations for the three months ended September 30, 2019 related to activity presented in the preceding table:


	Net gains on
(in thousands)	bonds (1)
Additional realized gains recognized	$	2,156
Total net gains reported in earnings	$	2,156

⁽¹⁾

Amounts are classified as “Net gains on bonds” in the Company’s Consolidated Statements of Operations.


	Investments
	in Debt		Derivative		Derivative
(in thousands)	Securities		Assets		Liabilities
Balance, July 1, 2018	$	162,261	$	2,747	$	(44)
Net losses included in earnings		─		(158)		(26)
Net change in AOCI (1)		(3,914)		─		─
Impact from sales or redemptions		(10,364)		─		─
Impact from settlements (2)		(175)		─		─
Balance, September 30, 2018	$	147,808	$	2,589	$	(70)

⁽¹⁾

This amount includes the reclassification into the Consolidated Statement of Operations of $5.1 million of net fair value gains related to bonds that were sold or redeemed. This decline was partially offset by (i) $1.0 million of net unrealized holding gains recognized during the period in connection with the Company’s bond investments and (ii) $0.1 million of realized losses that were reclassified out of AOCI and into the Consolidated Statements of Operations in connection with one of the Company’s bond investments that was assessed as OTTI.

⁽²⁾

This impact considers the effect of principal payments received and amortization of cost basis adjustments.

The following table provides information about the amount of realized and unrealized gains that were reported in the Company’s Consolidated Statements of Operations for the three months ended September 30, 2018, related to activity presented in the preceding table:



	Net losses on		Net gains on
(in thousands)	bonds (1)		derivatives (2)
Change in unrealized losses related to assets and liabilities held at September 30, 2018	$	─	$	(184)
Additional realized gains recognized		5,080		605
Total net gains reported in earnings	$	5,080	$	421

⁽¹⁾

Amounts are classified as “Impairments” and “Net gains on bonds” in the Company’s Consolidated Statements of Operations.

⁽²⁾

Amounts are classified as “Net (losses) gains on derivatives” in the Company’s Consolidated Statements of Operations.


	Investments
	in Debt		Derivative
(in thousands)	Securities		Assets
Balance, January 1, 2019	$	97,190	$	1,130
Net losses included in earnings		─		(195)
Net change in AOCI (1)		(25,118)		─
Impact from sales or redemptions		(37,633)		─
Impact from settlements (2)		(318)		(935)
Balance, September 30, 2019	$	34,121	$	─

⁽¹⁾

This amount represents the reclassification into the Consolidated Statements of Operations of $26.1 million of net fair value gains related to bonds that were sold or redeemed during this reporting period. This decline was partially offset by $1.0 million of net unrealized gains recognized during this reporting period in connection with the Company’s bond investments.

⁽²⁾

This impact considers the effect of principal payments received and amortization of cost basis adjustments. Included in this amount is $0.3 million of cumulative transition adjustment to retained earnings that was recognized in connection with the Company’s adoption of ASU No. 2017-08, “Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-10): Premium Amortization on Purchased Callable Debt Securities” on January 1, 2019.

The following table provides information about the amount of realized and unrealized gains (losses) that were reported in the Company’s Consolidated Statements of Operations for the nine months ended September 30, 2019, related to activity presented in the preceding table:


	Net gains on		Net losses on
(in thousands)	bonds (1)		derivatives (2)
Change in unrealized losses related to assets and liabilities held at January 1, 2019, but settled during 2019	$	─	$	(195)
Additional realized gains recognized		26,420		152
Total net gains (losses) reported in earnings	$	26,420	$	(43)

⁽¹⁾

Amounts are classified as “Net gains on bonds” in the Company’s Consolidated Statements of Operations.

⁽²⁾

Amounts are classified as “Net (losses) gains on derivatives” in the Company’s Consolidated Statements of Operations.


	Investments
	in Debt		Derivative		Derivative
(in thousands)	Securities		Assets		Liabilities
Balance, January 1, 2018	$	143,604	$	2,347	$	(46)
Net (losses) gains included in earnings		(6)		242		(24)
Net change in AOCI (1)		(2,931)		─		─
Impact from deconsolidation		17,997		─		─
Impact from sales or redemptions		(10,364)		─		─
Impact from settlements (2)		(492)		─		─
Balance, September 30, 2018	$	147,808	$	2,589	$	(70)

⁽¹⁾

This amount represents the reclassification into the Consolidated Statements of Operations of $5.1 million of net fair value gains related to bonds that were sold or redeemed during this reporting period. This decline was partially offset by $2.1 million of net unrealized holding gains recognized during the period in connection with the Company’s bond investments.

⁽²⁾

This impact considers the effect of principal payments received and amortization of cost basis adjustments.

The following table provides information about the amount of realized and unrealized (losses) gains that were reported in the Company’s Consolidated Statements of Operations for the nine months ended September 30, 2018, related to activity presented in the preceding table:



	Net losses on		Net gains on
(in thousands)	bonds (1)		derivatives (2)
Change in unrealized (losses) gains related to assets and liabilities held at September 30, 2018	$	(6)	$	218
Additional realized gains recognized		5,080		1,842
Total net gains reported in earnings	$	5,074	$	2,060

⁽¹⁾

Amounts are classified as “Impairments” and “Net gains on bonds” in the Company’s Consolidated Statements of Operations.

⁽²⁾

Amounts are classified as “Net (losses) gains on derivatives” in the Company’s Consolidated Statements of Operations.

Fair Value Measurements of Instruments That Are Classified as Level 3

We use valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.

For our Level 3 assets and liabilities, we generally use a discounted cash flow valuation technique to measure fair value. This type of valuation technique involves developing a projection of expected future cash flows of an instrument and then discounting such cash flows using discount factors that consider the relative risk of the cash flows and the time value of money. In applying this technique, the rate of return, or market yield, that is utilized for such purposes reflects specific characteristics of an instrument including, but not limited to the expected term of the instrument, its debt service coverage ratio or credit quality, geographic location, investment size and other attributes:

For performing multifamily bonds and TRS derivatives, the Company’s projection of expected future cash flows reflects cash flows that are contractually due over the life of an instrument. Such projected cash flows are discounted based upon the market yield of such instruments. For such instruments, the Company determines market yield by generally utilizing the AAA Municipal Market Data tax-exempt rate (“MMD”) for each instrument’s specific term and applies a market rate risk premium spread that reflects that instrument’s specific credit characteristics, such as size, debt service coverage, state or bond type.

For non-performing bonds and subordinate cash flow bonds, the Company’s projection of expected future cash flows reflects internally-generated projections over a 10‑year investment period of future net operating income (“NOI”) from the underlying properties that serve as collateral for our instruments. A terminal value, less estimated costs of sale, is then added to the projected discounted projection to reflect the remaining value that is expected to be generated at the end of the projection period. The Company utilizes geographic and sector specific discount rates that are published by an independent real estate research organization. For purposes of projecting expected future cash flows associated with non-performing bonds, the Company may also consider either quotes received from third parties or contract prices associated with a purchase and sale agreement related to underlying properties that serve as collateral for our instruments. In instances where the Company uses more than one valuation technique to measure the fair value of underlying properties, the results (respective indications of fair value) are evaluated and weighted, as appropriate, considering the reasonableness of the range indicated by those results.

For our infrastructure bond investment, the Company determines market yield by generally utilizing the AAA MMD tax-exempt rate for each infrastructure bond’s specific term and applies a market rate risk premium spread that reflects the instrument’s specific credit characteristics. Contractually due cash flows are discounted based upon the market yield of such instruments as of such reporting date.

Significant unobservable inputs presented in the tables that follow are those we consider significant to the fair value of the Level 3 asset or liability. We consider unobservable inputs to be significant if, by their exclusion, the fair value of the Level 3 asset or liability would be impacted by a predetermined percentage change, or based on qualitative factors, such as nature of the instrument, type of valuation technique used and the significance of the unobservable inputs relative to other inputs used within the valuation. Following is a description of the significant unobservable inputs that are referenced in the tables below:

Market yield – is a market rate of return used to calculate the present value of future expected cash flows to arrive at the fair value of an instrument. The market yield typically consists of a benchmark rate component and a risk premium component. The benchmark rate component, for example, MMD or SIFMA, is generally observable within the market and is necessary to appropriately reflect the time value of money. The risk premium component reflects the amount of compensation market participants require due to the uncertainty inherent in the instrument’s cash flows resulting from risks such as credit and liquidity. A significant decrease in this input in isolation would result in a significantly higher fair value measurement.

Capitalization rate – is calculated as the ratio between the NOI produced by a commercial real estate property and the price for such asset. A significant decrease in this input in isolation would result in a significantly higher fair value measurement.

NOI annual growth rate – is the amount of future growth in NOI that the Company projects each property to generate on an annual basis over the 10‑year projection period. These annual growth estimates take into account the Company’s expectation about the future increases, or decreases, in rental rates, vacancy rates, bad debt expense, concessions and operating expenses for each property. Generally, an increase in NOI will result in an increase to the fair value of the property.

Valuation technique weighting factors – represent factors that, in the aggregate, sum to 100% and that are individually applied to two or more indications of fair value considering the reasonableness of the range indicated by those results.

Contract price – represents a third-party sale agreement executed in connection with the pending sale of an affordable housing property that secures one of the Company’s bond investments. Estimated proceeds from the sale of such property that are determined to be allocable to a bond investment are used to measure such investment’s fair value at a given reporting date.

The tables that follow provide quantitative information about the valuation techniques and the range and weighted-average of significant unobservable inputs used in the valuation of substantially all of our Level 3 assets and liabilities measured at fair value on a recurring basis for which we use an internal model to measure fair value. The significant unobservable inputs for Level 3 assets and liabilities that are valued using dealer pricing are not included in the tables, as the specific inputs applied are not provided by the dealer.

Fair Value Measurement at September 30, 2019

Significant

Valuation

Unobservable

Weighted

(dollars in thousands)

Fair Value

Techniques

Inputs (1)

Range (1)

Average

Recurring Fair Value Measurements:

Investments in debt securities:

Multifamily tax-exempt bonds

Subordinated cash flow

8,721

Discounted cash flow

Market yield

7.3

N/A

Capitalization rate

6.4

N/A

NOI annual growth rates

0.6

N/A

Contract price

16,100

N/A

Infrastructure Bond

25,400

Discounted cash flow

Market yield

7.1

N/A

⁽¹⁾

Unobservable inputs reflect information that is not based upon independent sources that are readily available. These inputs are based upon assumptions and internally generated data made by the Company, which may include significant judgment that has been developed based upon available information from third-party sources or dealers about what a market participant would use in valuing the asset.

Fair Value Measurement at December 31, 2018

Significant

Valuation

Unobservable

Weighted

(dollars in thousands)

Fair Value

Techniques

Inputs (1)

Range (1)

Average (2)

Recurring Fair Value Measurements:

Investments in debt securities:

Multifamily tax-exempt bonds

Performing

48,221

Discounted cash flow

Market yield

4.4 - 6.8

4.8

Non-performing

12,882

Discounted cash flow

Market yield

8.2

N/A

Capitalization rate

7.0

N/A

Valuation technique
weighting factors:

• NOI annual growth
rate (10% weighting
factor)

0.5

N/A

• Contract price
(90% weighting
factor)

13,500

N/A

Subordinated cash flow

11,114

Discounted cash flow

Market yield

7.4 - 7.6

7.5

Capitalization rate

6.2 - 6.5

6.4

NOI annual growth rates

0.6 - 0.7

0.7

Infrastructure Bond

24,973

Discounted cash flow

Market yield

7.2

N/A

Derivative instruments:

Total return swaps

1,130

Discounted cash flow

Market yield

4.7 - 4.8

4.8

⁽¹⁾

⁽²⁾

Weighted-averages are calculated using outstanding UPB for cash instruments, such as loans and securities, and notional amounts for derivative instruments.

Nonrecurring Changes in Fair Value

During the nine months ended September 30, 2018, the Company recognized $0.4 million of impairment losses associated with certain equity investments based upon the fair value of such instruments. Fair value measurements of these instruments, which were categorized as Level 3 in the fair value hierarchy, were completed using a discounted cash flow methodology. There were no nonrecurring fair value adjustments recorded for the nine months ended September 30, 2019.

Additional Disclosures Related To The Fair Value of Financial Instruments That Are Not Carried On The Consolidated Balance Sheets at Fair Value

The tables that follow provide information about the carrying amounts and fair values of those financial instruments of the Company for which fair value is not measured on a recurring basis and organizes such information based upon the level of the fair value hierarchy within which fair value measurements are categorized. Assets and liabilities that do not represent financial instruments (e.g., premises and equipment) are excluded from these disclosures.

September 30, 2019

Carrying

Fair Value

(in thousands)

Amount

Level 1

Level 2

Level 3

Assets:

Cash and cash equivalents

10,837

─

Restricted cash

6,115

─

Loans held for investment

87,267

─

88,279

Liabilities:

Notes payable and other debt - non-bond related

10,295

─

9,738

Subordinated debt issued by MFH

96,045

─

44,238

Revolving credit facility obligations

45,000

─

45,000

December 31, 2018

Carrying

Fair Value

(in thousands)

Amount

Level 1

Level 2

Level 3

Assets:

Cash and cash equivalents

28,243

─

Restricted cash

5,635

─

Loans held for investment

67,299

─

66,339

Liabilities:

Notes payable and other debt - bond related

39,255

─

39,289

Notes payable and other debt - non-bond related

12,210

─

11,479

Subordinated debt issued by MFH

97,722

─

46,778

Valuation Techniques

Cash and cash equivalents and restricted cash – The carrying value of these assets approximated fair value due to the short-term nature and negligible credit risk inherent in them.

Loans held for investment – Fair value is measured using a discounted cash flow methodology pursuant to which contractual payments are discounted based upon market yields for similar credit risks.

Notes payable and other debt – Fair value is measured by discounting contractual cash flows using a market rate of interest or by estimating the fair value of the collateral supporting a debt arrangement, taking into account credit risk.

Subordinated debt – Fair value is measured by discounting projected contractual payments of principal and interest using such instrument’s estimated market yield, which was 12.0% and 13.4% at September 30, 2019 and December 31, 2018, respectively. As outlined in the table above, at September 30, 2019, the aggregate fair value was measured at $44.2 million. At September 30, 2019, the measured fair value of this debt would have been $53.3 million and $37.5 million had its market yield been 9.5% and 14.5%, respectively, as of such reporting date. The measured fair value of this debt is inherently judgmental and based on management’s assumption of market yields. There can be no assurance that the Company could repurchase the remaining subordinated debt at the measured fair values reflected in the table above or that the debt would trade at that price.

Revolving credit facility obligations – Fair value of these debt obligations is measured by discounting projected contractual payments of interest and principal using an estimated market yield.