Fair Value of Financial Instruments

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of valuation hierarchy are defined as follows:

Level 1 — inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 — inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 — inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The following describes the valuation methodologies used for the Company’s financial instruments measured at fair value on a recurring basis, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Securities Obtained and Pledged as Collateral/Obligation to Return Securities Obtained as Collateral

The fair value of U.S. Treasury securities obtained as collateral and the associated obligation to return securities obtained as collateral are based upon prices obtained from a third-party pricing service, which are indicative of market activity. Securities obtained as collateral are classified as Level 1 in the fair value hierarchy.

Agency MBS and Non-Agency MBS

The Company determines the fair value of its Agency MBS, based upon prices obtained from third-party pricing services, which are indicative of market activity and repurchase agreement counterparties.

For Agency MBS, the valuation methodology of the Company’s third-party pricing services incorporate commonly used market pricing methods, trading activity observed in the marketplace and other data inputs. The methodology also considers the underlying characteristics of each security, which are also observable inputs, including: collateral vintage; coupon; maturity date; loan age; reset date; collateral type; periodic and life cap; geography; and prepayment speeds. Management analyzes pricing data received from third-party pricing services and compares it to other indications of fair value including data received from repurchase agreement counterparties and its own observations of trading activity observed in the marketplace.

In determining the fair value of its Non-Agency MBS and securitized debt, management considers a number of observable market data points, including prices obtained from pricing services and brokers as well as dialogue with market participants. In valuing Non-Agency MBS, the Company understands that pricing services use observable inputs that include, in addition to trading activity observed in the marketplace, loan delinquency data, credit enhancement levels and vintage, which are taken into account to assign pricing factors such as spread and prepayment assumptions. For tranches that are cross-collateralized, performance of all collateral groups involved in the tranche are considered. The Company collects and considers current market intelligence on all major markets, including benchmark security evaluations and bid-lists throughout the day from various sources, when available.

The Company’s MBS and securitized debt are valued using various market data points as described above, which management considers directly or indirectly observable parameters. Accordingly, the Company’s MBS are classified as Level 2 in the fair value hierarchy.

Derivative Instruments

Linked Transactions

The Non-Agency MBS underlying the Company’s Linked Transactions are valued using similar techniques to those used for the Company’s other Non-Agency MBS. The value of the underlying MBS is then netted against the carrying amount (which approximates fair value) of the repurchase agreement borrowing at the valuation date. The fair value of Linked Transactions also includes accrued interest receivable on the MBS and accrued interest payable on the underlying repurchase agreement borrowings. The Company’s Linked Transactions are classified as Level 2 in the fair value hierarchy.

Swaps

The Company determines the fair value of non-centrally cleared Swaps considering valuations obtained from a third-party pricing service. For Swaps that are cleared by a central clearing house valuations provided by the clearing house are used. All valuations obtained are tested with internally developed models that apply readily observable market parameters. The Company considers the creditworthiness of both the Company and its counterparties, along with collateral provisions contained in each derivative agreement, from the perspective of both the Company and its counterparties. All of the Company’s Swaps are subject either to bilateral collateral arrangements, or for cleared Swaps, to the clearing house’s margin requirements. Consequently, no credit valuation adjustment was made in determining the fair value of such instruments. Swaps are classified as Level 2 in the fair value hierarchy.

The following table presents the Company’s financial instruments carried at fair value on a recurring basis as of June 30, 2014, on the consolidated balance sheet by the valuation hierarchy, as previously described:

Fair Value at June 30, 2014



(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	6,549,451	$	—	$	6,549,451
Non-Agency MBS, including MBS transferred to consolidated VIEs	—		5,001,337		—		5,001,337
Securities obtained and pledged as collateral	446,375		—		—		446,375
Linked Transactions	—		106,859		—		106,859
Swaps	—		2,755		—		2,755
Total assets carried at fair value	$	446,375	$	11,660,402	$	—	$	12,106,777
Liabilities:
Swaps	$	—	$	57,426	$	—	$	57,426
Obligation to return securities obtained as collateral	446,375		—		—		446,375
Total liabilities carried at fair value	$	446,375	$	57,426	$	—	$	503,801

Changes to the valuation methodologies used with respect to the Company’s financial instruments are reviewed by management to ensure any such changes result in appropriate exit price valuations. As markets and products develop and the pricing for certain products becomes more transparent, the Company continues to refine its valuation methodologies. The methods described above may produce fair value estimates that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company believes its valuation methods are appropriate and consistent with those used by market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced. The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, and management may conclude that its financial instruments should be reclassified to a different level in the future.

The following table presents the carrying values and estimated fair values of the Company’s financial instruments at fair value, at June 30, 2014 and December 31, 2013:



	June 30, 2014				December 31, 2013
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
(In Thousands)
Financial Assets:
Agency MBS	$	6,549,451	$	6,549,451	$	6,519,221	$	6,519,221
Non-Agency MBS, including MBS transferred to consolidated VIEs	5,001,337		5,001,337		4,852,137		4,852,137
Securities obtained and pledged as collateral	446,375		446,375		383,743		383,743
Cash and cash equivalents	343,719		343,719		565,370		565,370
Restricted cash	54,430		54,430		37,520		37,520
Linked Transactions	106,859		106,859		28,181		28,181
Swaps	2,755		2,755		13,000		13,000
Residential whole loans	59,746		59,746		—		—
Financial Liabilities:
Repurchase agreements	8,384,101		8,383,492		8,339,297		8,339,071
Securitized debt	214,048		214,821		366,205		366,767
Obligation to return securities obtained as collateral	446,375		446,375		383,743		383,743
Senior Notes	100,000		104,720		100,000		98,000
Swaps	57,426		57,426		28,217		28,217

In addition to the methodologies used to determine the fair value of the Company’s financial assets and liabilities reported at fair value on a recurring basis, as previously described, the following methods and assumptions were used by the Company in arriving at the fair value of the Company’s other financial instruments presented in the above table:

Cash and Cash Equivalents and Restricted Cash: Cash and cash equivalents and restricted cash are comprised of cash held in overnight money market investments and demand deposit accounts. At June 30, 2014 and December 31, 2013, the Company’s money market funds were invested in securities issued by the U.S. Government, or its agencies, instrumentalities, and sponsored entities, and repurchase agreements involving the securities described above. Given the overnight term and assessed credit risk, the Company’s investments in money market funds are determined to have a fair value equal to their carrying value.

Repurchase Agreements: The fair value of repurchase agreements reflects the present value of the contractual cash flows discounted at market interest rates at the valuation date for repurchase agreements with a term equivalent to the remaining term to interest rate repricing, which may be at maturity. Such interest rates are estimated based on LIBOR rates observed in the market. The Company’s repurchase agreements are classified as Level 2 in the fair value hierarchy.

Securitized Debt: In determining the fair value of securitized debt, management considers a number of observable market data points, including prices obtained from pricing services and brokers as well as dialogue with market participants. Accordingly, the Company's securitized debt is classified as Level 2 in the fair value hierarchy.

Senior Notes: The fair value of Senior Notes is determined using the end of day market price quoted on the NYSE at the reporting date. The Company’s Senior Notes are classified as Level 1 in the fair value hierarchy.

Residential Whole Loans: The fair value of residential whole loans is estimated taking into consideration current interest rates, loan amount, payment status and property type, and forecasts of future interest rates, home prices and property values, prepayment speeds, default, loss severities, and actual purchases and sales of similar loans. The Company’s residential whole loans are classified as Level 3 in the fair value hierarchy.