21. Fair Value of Financial Instruments

GAAP establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial instruments at fair values. GAAP establishes market-based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs. The three levels of the hierarchy are described below:

Level I— Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

Level II— Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

Level III— Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

We have implemented valuation control processes to validate the fair value of our financial instruments measured at fair value including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and the assumptions are reasonable. Refer to our Form 10-K for further discussion of our valuation control process.

We determine the fair value of our assets and liabilities measured at fair value on a recurring and nonrecurring basis in accordance with the methodology described in our Form 10-K. For those assets and liabilities acquired in connection with our acquisition of LNR, and arising due to other material transactions, and measured at fair value on a recurring or nonrecurring basis, we have determined fair value as follows:

Available-for-sale CMBS

Available-for-sale CMBS are valued utilizing both observable and unobservable market inputs. These factors include projected future cash flows, ratings, subordination levels, vintage, remaining lives, credit issues, recent trades of similar securities and the spreads used in the prior valuation. We obtain current market spread information where available and use this information in evaluating and validating the market price of all CMBS. Depending upon the significance of the fair value inputs used in determining these fair values, these securities are classified in either Level II or Level III of the fair value hierarchy. CMBS may shift between Level II and Level III of the fair value hierarchy if the significant fair value inputs used to price the CMBS become or cease to be observable.

Derivatives

The valuation of derivative contracts are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market based inputs, including interest rate curves, spot and market forward points and implied volatilities. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.

We incorporate credit valuation adjustments to appropriately reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, we have considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.

Although we have determined that the majority of the inputs used to value our derivatives fall within Level II of the fair value hierarchy, the credit valuation adjustments associated with our derivatives utilize Level III inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2013, we have assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our derivative positions and have determined that the credit valuation adjustments are not as significant to the overall valuation of our derivatives. As a result, we have determined that our derivative valuations in their entirety are classified in Level II of the fair value hierarchy.

As of January 1, 2013, the Company changed its valuation methodology for over-the-counter (“OTC”) derivatives to discount cash flows based on Overnight Index Swap (“OIS”) rates. Fully collateralized trades are discounted using OIS with no additional economic adjustments to arrive at fair value. Uncollateralized or partially-collateralized trades are also discounted at OIS, but include appropriate economic adjustments for funding costs (i.e., a LIBOR-OIS basis adjustment to approximate uncollateralized cost of funds) and credit risk. The Company is making the changes to better align its inputs, assumptions, and pricing methodologies with those used in its principal market by most dealers and major market participants. The changes in valuation methodology are applied prospectively as a change in accounting estimate and are immaterial to the Company’s financial statements.

For credit index instruments acquired in connection with our acquisition of LNR, fair value is determined based on changes in the relevant indices from the date of initiation of the instrument to the reporting date, as these changes determine the amount of any future cash settlement between us and the counterparty. These indices are considered Level II inputs as they are directly observable. We have assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our credit index instruments and have determined that any credit valuation adjustment would not be significant to the overall valuation as the counterparty to these contracts is a highly rated global financial institution. As a result, we have determined that credit index instruments are classified in Level II of the fair value hierarchy.

Loans held-for-investment

The fair value of our loans held-for-investment acquired in connection with our acquisition of LNR is based on the estimated fair value of the underlying real estate, which was determined through a combination of appraisals, discounted future cash flows and market capitalization rates. Since the most significant of these inputs are unobservable, we have determined that the fair value of these loans in their entirety should be classified in Level III of the fair value hierarchy.

Loans held-for-sale

We measure the fair value of our mortgage loans held-for-sale within LNR’s conduit platform using a discounted cash flow analysis unless observable market data (i.e. securitized pricing) is available. A discounted cash flow analysis requires management to make estimates regarding future interest rates and credit spreads. The most significant of these inputs relates to credit spreads and is unobservable. Thus, we have determined that the fair values of mortgage loans valued using a discounted cash flow analysis should be classified in Level III of the fair value hierarchy, while mortgage loans valued using securitized pricing should be classified in Level II of the fair value hierarchy. Mortgage loans classified in Level III are transferred to Level II if securitized pricing becomes available.

Intangible asset — Domestic servicing rights

The fair value of this intangible is determined using discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows, including forecasted loan defeasance, delinquency and anticipated maturity defaults which are calculated assuming a debt yield at which default occurs. Since the most significant of these inputs are unobservable, we have determined that the fair values of these intangibles in their entirety should be classified in Level III of the fair value hierarchy.

Intangible assets — European servicing rights

The fair value of this intangible was determined using discounted cash flow modeling techniques which require management to make estimates regarding future net servicing cash flows. Since the most significant of these inputs are unobservable, we have determined that the fair values of these intangibles in their entirety should be classified in Level III of the fair value hierarchy.

Non-performing residential loans

We estimate the fair value of our non-performing loans by applying an estimated current market discount to the estimated fair value of the underlying residential property collateral.

Investment in unconsolidated entities

The fair value of these investments acquired in connection with our acquisition of LNR was determined using discounted expected future cash flows from the ventures. Since these inputs are unobservable, we have determined that the fair values of these investments should be classified in Level III of the fair value hierarchy at the date of our acquisition of LNR.

Liabilities of consolidated VIEs

We utilize several inputs and factors in determining the fair value of VIE liabilities, including future cash flows, market transaction information, ratings, subordination levels, and current market spread and pricing information where available. Quoted market prices are used when this debt trades as an asset. Depending upon the significance of the fair value inputs used in determining these fair values these liabilities are classified in either Level II or Level III of the fair value hierarchy. VIE liabilities may shift between Level II and Level III of the fair value hierarchy if the significant fair value inputs used to price the VIE liabilities become observable or cease to be observable.

Assets of consolidated VIEs

The VIEs in which we invest are “static”; that is, no reinvestment is permitted, and there is no active management of the underlying assets. In determining the fair value of the assets of the VIE, we maximize the use of observable inputs over unobservable inputs. We also acknowledge that our principal market for selling CMBS assets is the securitization market where the market participant is considered to be a CMBS trust or a CDO. This methodology results in the fair value of the assets of a static CMBS trust being equal to the fair value of its liabilities. The individual assets of a VIE are inherently incapable of precise measurement given their illiquid nature and the limitations on available information related to these assets. Because our methodology for valuing these assets does not value the individual assets of a VIE, but rather uses the value of the VIE liabilities as an indicator of the fair value of VIE assets as a whole, we have determined that our valuations of VIE assets in their entirety should be classified in Level III of the fair value hierarchy.

Secured financing agreements

The fair value of the secured financing agreements acquired in connection with our acquisition of LNR approximates the carrying value of these instruments due to their short-term nature.

Convertible senior notes

The fair value of our convertible senior notes is estimated by discounting the contractual cash flows at the interest rate we estimate such notes would bear if sold in the current market.

Non-controlling interests

The fair value of non-controlling interests acquired in connection with our acquisition of LNR are based on the estimated underlying fair value of equity associated with the non-wholly owned consolidated entity. This fair value is determined using a combination of the above techniques, depending upon the exact nature of the assets and liabilities of the entity. Since most of these inputs are unobservable, we have determined that the fair value of non-controlling interests at the date of our acquisition of LNR should be classified in Level III of the fair value hierarchy.

The following table presents our financial instruments carried at fair value on a recurring basis in the consolidated balance sheet by their level in the fair value hierarchy as of September 30, 2013 (amounts in thousands):

	September 30, 2013
	Total		Level I		Level II		Level III
Financial Assets:
Loans held-for-sale, fair value option	$	279,121	$	—	$	—	$	279,121
RMBS	316,261		—		—		316,261
CMBS	198,146		—		—		198,146
Domestic servicing rights	158,023		—		—		158,023
Equity securities	15,016		15,016		—		—
Derivative assets	9,513		—		9,513		—
VIE assets	97,359,666		—		—		97,359,666
Total	$	98,335,746	$	15,016	$	9,513	$	98,311,217

Financial Liabilities:
Derivative liabilities	$	32,252	$	—	$	32,252	$	—
VIE liabilities	96,934,006		—		95,150,366		1,783,640
Total	$	96,966,258	$	—	$	95,182,618	$	1,783,640

During the three and nine months ended September 30, 2013, we transferred $5.1 million and $117.4 million, respectively, of CMBS investments from Level II to Level III due to a decrease in the observable, relevant market activity.

The changes in financial instruments classified as Level III are as follows for the three months ended September 30, 2013 (amounts in thousands):

	Loans Held- for-sale			RMBS			CMBS			Domestic Servicing Rights			VIE assets			VIE liabilities			Total
Beginning balance, June 30, 2013	$	171,176		$	319,655		$	164,399		$	159,891		$	97,284,473		$	(2,334,660	)	$	95,764,934
Total realized and unrealized (losses) gains:
Included in earnings:
Change in fair value	25,856			—			4,620			(1,868		)	(4,283,956		)	239,094			(4,016,254		)
Impairment	—			(52		)	—			—			—			—			(52		)
Included in other comprehensive income	—			4,842			474			—			—			—			5,316
Net accretion	—			5,940			—			—			—			—			5,940
Purchases / Originations	457,468			—			23,871			—			—			—			481,339
Sales	(375,204		)	—			—			—			—			—			(375,204		)
Issuances	—			—			—			—			—			(8,760		)	(8,760		)
Cash repayments / receipts	(175		)	(14,124		)	(163		)	—			—			(5,041		)	(19,503		)
Transfers into Level III	—			—			5,098			—			—			(88,806		)	(83,708		)
Transfers out of Level III	—			—			—			—			—			483,608			483,608
Consolidations of VIEs	—			—			—			—			4,359,149			(69,075		)	4,290,074
Deconsolidations of VIEs	—			—			(153		)	—			—			—			(153		)
Ending balance, as of September 30, 2013	$	279,121		$	316,261		$	198,146		$	158,023		$	97,359,666		$	(1,783,640	)	$	96,527,577
Amount of total (losses) gains included in earnings attributable to assets still held at September 30, 2013	$	6,011		7,057			5,428			(1,868		)	(4,283,956		)	239,094			$	(4,028,234	)

The changes in financial instruments classified as Level III are as follows for the nine months ended September 30, 2013 (amounts in thousands):

	Loans Held- for-sale			RMBS			CMBS			Domestic Servicing Rights		VIE assets			VIE liabilities			Total
Beginning balance, December 31, 2012	$	—		$	333,153		$	—		$	—	$	—		$	—		$	333,153
Acquisition of LNR	256,502			—			62,432			156,993		90,989,793			(1,994,243		)	89,471,477
Total realized and unrealized (losses) gains:
Included in earnings:																		—
Change in fair value	26,315			2,129			3,452			1,030		(8,078,597		)	333,542			(7,712,129		)
Impairment	—			(453		)	—			—		—			—			(453		)
Included in other comprehensive income	—			2,970			2,382			—		—			—			5,352
Net accretion	—			17,846			—			—		—			—			17,846
Purchases / Originations	848,137			20,090			23,910			—		—			—			892,137
Sales	(851,539		)	(12,712		)	(10,072		)	—		—			—			(874,323		)
Issuances	—			—			—			—		—			(8,760		)	(8,760		)
Cash repayments / receipts	(294		)	(46,762		)	(163		)	—		—			74,694			27,475
Transfers into Level III	—			—			117,413			—		—			(578,319		)	(460,906		)
Transfers out of Level III	—			—			—			—		—			636,291			636,291
Consolidations of VIEs	—			—			(1,208		)	—		15,033,274			(247,706		)	14,784,360
Deconsolidations of VIEs	—			—			—			—		(584,804		)	861			(583,943		)
Ending balance, as of September 30, 2013	$	279,121		$	316,261		$	198,146		$	158,023	$	97,359,666		$	(1,783,640	)	$	96,527,577
Amount of total (losses) gains included in earnings attributable to assets still held at September 30, 2013	$	6,011		21,363			1,854			1,030		(8,078,597		)	333,542			$	(7,714,797	)

	December 31, 2012
	Total			Level I		Level II			Level III
Available-for-sale debt securities:
RMBS	$	333,153		$	—	$	—		$	333,153
CMBS	529,434			—		529,434			—
Total available-for-sale debt securities	862,587			—		529,434			333,153
Available-for-sale equity securities:
Real estate industry	21,667			21,667		—			—
Total available-for-sale equity securities:	21,667			21,667		—			—
Total investments	884,254			21,667		529,434			333,153
Derivative assets:
Foreign exchange contracts	$	4,335		$	—	$	4,335		$	—
Interest rate contracts	4,892			—		4,892			—
Derivatives liabilities:
Interest rate contracts	(4,343		)	—		(4,343		)	—
Foreign exchange contracts	(23,427		)	—		(23,427		)	—
Total derivatives	(18,543		)	—		(18,543		)	—
Total	$	865,711		$	21,667	$	510,891		$	333,153

The changes in investments classified as Level III are as follows for the three months ended September 30, 2012 (amounts in thousands):

Fair Value Measurements Using Significant Unobservable Inputs

(Level III)

	Loans held-for-sale, at fair value		MBS available- for-sale, at fair value			Total
Beginning balance, June 30, 2012	$	—	$	233,456		$	233,456
Purchases	—		95,814			95,814
Originations	—		—			—
Transfer out	—		—			—
Sales	—		(9,425		)	(9,425		)
Maturities	—		—			—
Principal amortization	—		(18,542		)	(18,542		)
Net decrease in assets	—		67,847			67,847
Gain (loss) amounts from Level III investments:
Unrealized (loss) gain on assets	—		30,575			30,575
Realized gain on assets	—		730			730
Accretion of discount	—		5,924			5,924
OTTI	—		(637		)	(637		)
Other	—		5			5
Net gain on assets	—		36,597			36,597
Ending balance, as of September 30, 2012	$	—	$	337,900		$	337,900

The changes in investments classified as Level III are as follows for the nine months ended September 30, 2012 (amounts in thousands):

Fair Value Measurements Using Significant Unobservable Inputs

(Level III)

	Loans held-for-sale, at fair value			MBS available- for-sale, at fair value			Total
Beginning balance, January 1, 2012	$	128,593		$	341,734		$	470,327
Purchases	—			203,433			203,433
Originations	—			—			—
Transfer out	—			(176,786		)	(176,786		)
Sales	(132,128		)	(26,049		)	(158,177		)
Maturities	—			—			—
Principal amortization	(122		)	(52,310		)	(52,432		)
Net decrease in assets	(132,250		)	(51,712		)	(183,962		)
Gain (loss) amounts from Level III investments:
Unrealized (loss) gain on assets	(5,760		)	34,371			28,611
Realized gain on assets	9,417			3,643			13,060
Accretion of discount	—			12,548			12,548
OTTI	—			(2,689		)	(2,689		)
Other	—			5			5
Net gain on assets	3,657			47,878			51,535
Ending balance, as of September 30, 2012	$	—		$	337,900		$	337,900

The following table presents the fair value of our financial instruments, which are classified as Level III, including loans transferred as secured borrowings, not carried at fair value on the condensed consolidated balance sheet (amounts in thousands):

	Carrying Value as of September 30, 2013		Fair Value as of September 30, 2013		Carrying Value as of December 31, 2012		Fair Value as of December 31, 2012
Financial instruments not carried at fair value:
Loans held-for-investment and loans transferred as secured borrowings	$	3,875,852	$	3,974,875	$	3,000,335	$	3,097,089
Loans held-for-sale	66,018		66,813		—		—
Securities, held-to-maturity	37,370		37,600		—		—
European servicing rights	29,709		31,448		—		—
Non-performing residential loans	197,716		203,700		68,883		68,883
Financial Liabilities:
Secured financing agreements, loan transfer secured borrowings, and loan participation liability	$	1,493,726	$	1,493,257	$	1,393,705	$	1,397,128
Convertible senior notes	995,072		1,102,300		—		—

The following is quantitative information about significant unobservable inputs in our Level III measurements for those assets and liabilities measured at fair value on a recurring basis (dollar amounts in thousands):

Quantitative Information about Level III Fair Value Measurements

	Carrying Value at September 30, 2013		Valuation Technique	Unobservable Input	Range (1)
Loans held-for-sale, fair value option	$	279,121	Discounted cash flow	Yield (b) Duration (c)	4.65% - 5.61% 5.0 to 10.0 years
RMBS	316,261		Discounted cash flow	Constant prepayment rate (a) Constant default rate (b) Loss severity (b) Delinquency Rate (c) Servicer Advances (a) Annual Coupon Deterioration (b) Putback Amount per Projected Total Collateral Loss (d)	(0.6)%-14.9% 2.0%-13.3% 10%-83%(e) 5%-47% 8%-100% 0.025%-0.18% 0%-9%
CMBS and CMBS, fair value option	198,146		Discounted cash flow	Yield (b) Duration (c)	0% to 767.0% 0 to 10.0 years
Domestic servicing rights	158,023		Discounted cash flow	Debt yield (a) Discount rate (b)	8.75% 15%
VIE assets	97,359,666		Discounted cash flow	Yield (b) Duration (c)	0% to 791.8% 0 to 23.5 years
VIE liabilities	1,783,640		Discounted cash flow	Yield (b) Duration (c)	0% to 791.8% 0 to 23.5 years

(1) The ranges of significant unobservable inputs are represented in percentages and years.

Sensitivity of the Fair Value to Changes in the Unobservable Inputs

(a) Significant increase (decrease) in the unobservable input in isolation would result in a significantly higher (lower) fair value measurement.

(b) Significant increase (decrease) in the unobservable input in isolation would result in a significantly lower (higher) fair value measurement.

(c) Significant increase (decrease) in the unobservable input in isolation would result in either a significantly lower or higher (lower or higher) fair value measurement depending on the structural features of the security in question.

(d) Any delay in the Putback Recovery Date leads to a decrease in fair value, for the majority of securities in our RMBS portfolio.

(e) 90% of the portfolio falls within a range of 40%-80%.