NOTE 9. FAIR VALUES OF FINANCIAL INSTRUMENTS

As defined in ASC 820‑10, fair value is the price that would be received from the sale of an asset or paid to transfer or settle a liability in an orderly transaction between market participants in the principal (or most advantageous) market for the asset or liability. ASC 820‑10 establishes a fair value hierarchy that ranks the quality and reliability of the information used to determine fair values. Financial assets and liabilities carried at fair value are classified and disclosed in one of the three following categories:

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data. This includes those financial instruments that are valued using models or other valuation methodologies where substantially all of the assumptions are observable in the marketplace, can be derived from observable market data or are supported by observable levels at which transactions are executed in the marketplace. The valuation techniques, including the judgments or assumptions that are used by us in arriving at the fair value of our MBS and derivative instruments, are as follows:

The fair values for Agency MBS and TBA Agency MBS are based primarily on independent broker pricing quotes and independent third-party pricing service quotes, which are deemed indicative of market activity. The brokers and third-party pricing services use commonly used market pricing methodology that generally incorporate such factors as coupons, primary and secondary mortgage rates, rate reset period, issuer, loan age, collateral type, periodic and life cap, geography, and prepayment speeds. We evaluate the pricing information we receive taking into account factors such as coupon, prepayment experience, fixed/adjustable rate, coupon index, time to reset and issuing agency, among other factors. Based on these factors and our market knowledge and expertise, bond prices are compared to prices of similar securities and our own observations of trading activity in the marketplace.

The fair values for Non-Agency MBS are based primarily on prices from independent well-known major financial brokers that make markets in these instruments and pricing from independent pricing services. We understand that these market participants use pricing models that not only consider the characteristics of the type of security and its underlying collateral from observable market data but also consider the historical performance data of the underlying collateral of the security, including loan delinquency, loan losses, and credit enhancement. To validate the prices the Company obtains, we consider and review a number of observable market data points including trading activity in the marketplace, and current market intelligence on all major markets, including benchmark security evaluations and bid list results from various sources. We compare the prices received from brokers against the prices received from pricing services and vice-versa and also against our own internal models for reasonableness and make inquiries to the brokers and pricing services about the prices received from these parties and their methods.

For derivative instruments, the fair value is determined as follows: For all centrally cleared interest rate swaps (those entered into after September 9, 2013) pricing is provided by the central counterparty (large central clearing exchanges such as the Chicago Mercantile Exchange, or the CME, and LCH). These entities use pricing models that reference the underlying rates including the overnight index swap rate and LIBOR forward rate to produce the daily settlement price. To validate the prices for all interest rate swaps, we compare to other sources such as Bloomberg. At December 31, 2019, we did not have any non-centrally cleared swaps.

Level 3: Unobservable inputs that are not corroborated by market data. This is comprised of financial instruments whose fair value is estimated based on internally developed models or methodologies utilizing significant inputs that are generally less readily observable from objective sources.

At December 31, 2019 and December 31, 2018, fair value measurements on a recurring basis were as follows:

December 31, 2019


	Level 1		Level 2		Level 3		Total
	(in thousands)
Assets:
Agency MBS(1)	$	—	$	3,510,051	$	—	$	3,510,051
Non-Agency MBS(1)	$	—	$	643,610	$	—	$	643,610
Derivative instruments(2)	$	—	$	5,833	$	—	$	5,833
Liabilities:
Derivative instruments(2)	$	—	$	52,197	$	—	$	52,197

December 31, 2018


	Level 1		Level 2		Level 3		Total
	(in thousands)
Assets:
Agency MBS(1)	$	—	$	3,548,719	$	—	$	3,548,719
Non-Agency MBS(1)	$	—	$	795,203	$	—	$	795,203
Derivative instruments(2)	$	—	$	46,207	$	—	$	46,207
Liabilities:
Derivative instruments(2)	$	—	$	15,901	$	—	$	15,901

(1)

For more detail about the fair value of our MBS by agency and type of security, see Notes 1 and 3.

(2)

Derivative instruments include discontinued hedges under ASC 815‑10. For more detail about our derivative instruments, see Notes 1 and 15.

At December 31, 2019 and December 31, 2018, cash and cash equivalents, investments in U.S. Treasury bills, restricted cash, interest receivable, repurchase agreements, reverse repurchase agreements, warehouse line of credit, and interest payable are reflected in our consolidated financial statements at cost, which approximate fair value because of the nature and short term of these instruments.

Junior subordinated notes are variable-rate debt and, as we believe the spread would be consistent with the expectations of market participants as of December 31, 2019 and December 31, 2018, the carrying value approximates fair value.

The following table presents the carrying value and estimated fair value of the Company’s financial instruments that are not carried at fair value on the consolidated balance sheets at December 31, 2019 and December 31, 2018:


	December 31, 2019				December 31, 2018
	Carrying		Estimated		Carrying		Estimated
	Value		Fair Value		Value		Fair Value
	(in thousands)
Financial Assets:
Residential mortgage loans held-for-investment through consolidated securitization trusts	$	458,348	$	461,606	$	549,016	$	538,362
Residential mortgage loans held-for-securitization	$	152,922	$	154,442	$	11,660	$	11,660
Financial Liabilities:
Asset-backed securities issued by securitization trusts	$	448,987	$	450,501	$	539,651	$	528,045

The residential mortgage loans held-for-investment through consolidated securitization trusts or held-for-securitization are carried at unpaid principal balances net of any premiums or discounts and allowances for loan losses. Asset-backed securities issued by securitization trusts are carried at principal balances net of unamortized premiums or discounts. For both of these items, fair values are obtained by an independent broker and/or independent pricing services and are considered Level 2 in the fair value hierarchy.