20. Fair Value

GAAP establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial assets and liabilities at fair value. 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.

Valuation Process

We have valuation control processes in place to validate the fair value of the Company’s financial assets and liabilities 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.

Pricing Verification—We use recently executed transactions, other observable market data such as exchange data, broker/dealer quotes, third party pricing vendors and aggregation services for validating the fair values generated using valuation models. Pricing data provided by approved external sources is evaluated using a number of approaches; for example, by corroborating the external sources’ prices to executed trades, analyzing the methodology and assumptions used by the external source to generate a price and/or by evaluating how active the third party pricing source (or originating sources used by the third party pricing source) is in the market.

Unobservable Inputs—Where inputs are not observable, we review the appropriateness of the proposed valuation methodology to ensure it is consistent with how a market participant would arrive at the unobservable input. The valuation methodologies utilized in the absence of observable inputs may include extrapolation techniques and the use of comparable observable inputs.

Any changes to the valuation methodology will be reviewed by our management to ensure the changes are appropriate. The methods used may produce a fair value calculation that is not indicative of net realizable value or reflective of future fair values. Furthermore, while we anticipate that our valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value could result in a different estimate of fair value at the reporting date.

Fair Value on a Recurring Basis

We determine the fair value of our financial assets and liabilities measured at fair value on a recurring basis as follows:

Loans held-for-sale

We measure the fair value of our mortgage loans held-for-sale within the Investing and Servicing Segment’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.

RMBS

RMBS are valued utilizing observable and unobservable market inputs. The observable market inputs include recent transactions, broker quotes and vendor prices (“market data”). However, given the implied price dispersion amongst the market data, the fair value determination for RMBS has also utilized significant unobservable inputs in discounted cash flow models including prepayments, default and severity estimates based on the recent performance of the collateral, the underlying collateral characteristics, industry trends, as well as expectations of macroeconomic events (e.g., housing price curves, interest rate curves, etc.). At each measurement date, we consider both the observable and unobservable valuation inputs in the determination of fair value. However, given the significance of the unobservable inputs these securities have been classified within Level III.

CMBS

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.

Equity security

The equity security is publicly registered and traded in the United States and its market price is listed on the London Stock Exchange. The security has been classified within Level I.

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, control migration, 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 this intangible in its entirety should be classified in Level III of the fair value hierarchy.

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 our 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 us and our counterparties. However, as of December 31, 2016 and 2015, 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.

The valuation of over the counter (“OTC”) derivatives are determined using discounted 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.

For credit index instruments, 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.

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 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.

Fair Value Only Disclosed

We determine the fair value of our financial instruments and assets where fair value is disclosed as follows:

Loans held‑for‑investment and loans transferred as secured borrowings

We estimate the fair values of our loans not carried at fair value on a recurring basis by discounting their expected cash flows at a rate we estimate would be demanded by the market participants that are most likely to buy our loans. The expected cash flows used are generally the same as those used to calculate our level yield income in the financial statements. Since these inputs are unobservable, we have determined that the fair value of these loans in their entirety would be classified in Level III of the fair value hierarchy.

HTM securities

We estimate the fair value of our mandatorily redeemable preferred equity interests in commercial real estate companies using the same methodology described for our loans held‑for‑investment. We estimate the fair value of our HTM CMBS using the same methodology described for our CMBS carried at fair value on a recurring basis.

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 was unobservable, we have determined that the fair value of this intangible should be classified in Level III of the fair value hierarchy as of December 31, 2015.

Secured financing agreements, 2021 Notes and secured borrowings on transferred loans

The fair value of the secured financing agreements, 2021 Notes and secured borrowings on transferred loans are determined by discounting the contractual cash flows at the interest rate we estimate such arrangements would bear if executed in the current market. We have determined that our valuation of these instruments should be classified in Level III of the fair value hierarchy.

Convertible Notes

The fair value of the debt component of our Convertible 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 without the embedded conversion option which, in accordance with ASC 470, is reflected as a component of equity. We have determined that our valuation of our Convertible Notes should be classified in Level III of the fair value hierarchy.

Fair Value Disclosures

The following tables present our financial assets and liabilities carried at fair value on a recurring basis in the consolidated balance sheets by their level in the fair value hierarchy as of December 31, 2016 and 2015 (amounts in thousands):


	December 31, 2016
	Total		Level I		Level II		Level III
Financial Assets:
Loans held-for-sale, fair value option	$	63,279	$	—	$	—	$	63,279
RMBS		253,915		—		—		253,915
CMBS		31,546		—		—		31,546
Equity security		12,177		12,177		—		—
Domestic servicing rights		55,082		—		—		55,082
Derivative assets		89,361		—		89,361		—
VIE assets		67,123,261		—		—		67,123,261
Total	$	67,628,621	$	12,177	$	89,361	$	67,527,083
Financial Liabilities:
Derivative liabilities	$	3,904	$	—	$	3,904	$	—
VIE liabilities		66,130,592		—		63,545,223		2,585,369
Total	$	66,134,496	$	—	$	63,549,127	$	2,585,369


	December 31, 2015
	Total		Level I		Level II		Level III
Financial Assets:
Loans held-for-sale, fair value option	$	203,865	$	—	$	—	$	203,865
RMBS		176,224		—		—		176,224
CMBS		212,981		—		—		212,981
Equity security		14,498		14,498		—		—
Domestic servicing rights		119,698				—		119,698
Derivative assets		45,091		—		45,091		—
VIE assets		76,675,689		—		—		76,675,689
Total	$	77,448,046	$	14,498	$	45,091	$	77,388,457
Financial Liabilities:
Derivative liabilities	$	5,196	$	—	$	5,196	$	—
VIE liabilities		75,817,014		—		73,264,566		2,552,448
Total	$	75,822,210	$	—	$	73,269,762	$	2,552,448

The changes in financial assets and liabilities classified as Level III are as follows for the years ended December 31, 2016 and 2015 (amounts in thousands):


							Domestic
	Loans						Servicing				VIE
	Held‑for‑sale		RMBS		CMBS		Rights		VIE Assets		Liabilities		Total
January 1, 2015 balance	$	391,620	$	207,053	$	334,080	$	132,303	$	107,816,065	$	(4,893,120)	$	103,988,001
Total realized and unrealized gains (losses):
Included in earnings:
Change in fair value / gain on sale		64,320		—		(3,093)		(12,605)		(35,365,585)		3,980,376		(31,336,587)
Net accretion		—		20,625		—		—		—		—		20,625
Included in OCI		—		(16,210)		(2,363)		—		—		—		(18,573)
Purchases / Originations		1,848,879		—		14,653		—		—		—		1,863,532
Sales		(2,100,216)		—		(6,410)		—		—		—		(2,106,626)
Issuances		—		—		—		—		—		(9,132)		(9,132)
Cash repayments / receipts		(738)		(35,244)		(100,738)		—		—		304,816		168,096
Transfers into Level III		—		—		—		—		—		(2,920,033)		(2,920,033)
Transfers out of Level III		—		—		—		—		—		1,290,497		1,290,497
Consolidation of VIEs		—		—		(24,309)		—		12,050,421		(363,008)		11,663,104
Deconsolidation of VIEs		—		—		1,161		—		(7,825,212)		57,156		(7,766,895)
December 31, 2015 balance		203,865		176,224		212,981		119,698		76,675,689		(2,552,448)		74,836,009
Impact of ASU 2015-02 adoption (1)		—		—		—		(17,467)		17,467		—		—
Total realized and unrealized gains (losses):
Included in earnings:
Change in fair value / gain on sale		74,251		—		(1,421)		(47,149)		(25,141,786)		1,385,108		(23,730,997)
Net accretion		—		15,479		—		—		—		—		15,479
Included in OCI		—		7,622		—		—		—		—		7,622
Purchases / Originations		1,670,966		98,035		57,576		—		—		—		1,826,577
Sales		(1,884,380)		—		(18,725)		—		—		—		(1,903,105)
Issuances		—		—		—		—		—		(35,728)		(35,728)
Cash repayments / receipts		(1,423)		(43,445)		(58,435)		—		—		53,107		(50,196)
Transfers into Level III		—		—		—		—		—		(1,101,416)		(1,101,416)
Transfers out of Level III		—		—		—		—		—		268,915		268,915
Consolidation of VIEs		—		—		(162,745)		—		21,289,873		(648,352)		20,478,776
Deconsolidation of VIEs		—		—		2,315		—		(5,717,982)		45,445		(5,670,222)
December 31, 2016 balance	$	63,279	$	253,915	$	31,546	$	55,082	$	67,123,261	$	(2,585,369)	$	64,941,714
Amount of total gains (losses) included in earnings attributable to assets still held at:
December 31, 2015	$	155	$	15,131	$	3,134	$	(12,605)	$	(35,365,585)	$	3,980,376	$	(31,379,394)
December 31, 2016		214		15,479		(1,205)		(47,149)		(25,141,786)		1,385,108		(23,789,339)

(1)

As discussed in Notes 2 and 15, our implementation of ASU 2015-02 resulted in the consolidation of certain CMBS trusts effective January 1, 2016, which required the elimination of $17.5 million of domestic servicing rights associated with these newly consolidated trusts.

Amounts were transferred from Level II to Level III due to a decrease in the observable relevant market activity and amounts were transferred from Level III to Level II due to an increase in the observable relevant market activity.

The following table presents the fair values, all of which are classified in Level III of the fair value hierarchy, of our financial instruments not carried at fair value on the consolidated balance sheets (amounts in thousands):


	December 31, 2016				December 31, 2015
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Financial assets not carried at fair value:
Loans held-for-investment and loans transferred as secured borrowings	$	5,882,995	$	5,934,219	$	6,059,652	$	6,125,881
HTM securities		509,980		504,165		321,244		315,255
European servicing rights		—		—		2,626		5,302
Financial liabilities not carried at fair value:
Secured financing agreements and secured borrowings on transferred loans	$	4,189,126	$	4,198,136	$	4,068,699	$	4,092,264
Unsecured senior notes		2,011,544		2,088,374		1,323,795		1,331,979

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 (dollars in thousands):


	Carrying Value at		Valuation	Unobservable	Range as of December 31, (1)
	December 31, 2016		Technique	Input	2016	2015
Loans held-for-sale, fair value option	$	63,279	Discounted cash flow	Yield (b)	5.0% - 5.7%	4.8% - 5.3%
				Duration (c)	10.0 years	5.0 - 10.0 years
RMBS		253,915	Discounted cash flow	Constant prepayment rate (a)	2.8% - 17.0%	2.6% - 17.8%
				Constant default rate (b)	1.1% - 8.1%	1.0% - 8.9%
				Loss severity (b)	12% - 79% (e)	10% - 79% (e)
				Delinquency rate (c)	2% - 29%	2% - 29%
				Servicer advances (a)	23% - 94%	30% - 94%
				Annual coupon deterioration (b)	0% - 0.6%	0% - 0.5%
				Putback amount per projected total collateral loss (d)	0% - 15%	0% - 11%
CMBS		31,546	Discounted cash flow	Yield (b)	0% - 172.0%	0% - 435.8%
				Duration (c)	0 - 18.7 years	0 - 18.5 years
Domestic servicing rights		55,082	Discounted cash flow	Debt yield (a)	7.75%	8.25%
				Discount rate (b)	15%	15%
				Control migration (b)	0% - 80%	0% - 80%
VIE assets		67,123,261	Discounted cash flow	Yield (b)	0% - 960.4%	0% - 920.2%
				Duration (c)	0 - 12.0 years	0 - 17.5 years
VIE liabilities		2,585,369	Discounted cash flow	Yield (b)	0% - 960.4%	0% - 920.2%
				Duration (c)	0 - 12.0 years	0 - 17.5 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 (higher or lower) 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)

57% and 76% of the portfolio falls within a range of 45% ‑ 80% as of December 31, 2016 and 2015, respectively.