NOTE 8—FAIR VALUE MEASUREMENTS

The Company uses valuation techniques that are consistent with the market approach, the income approach, and/or the cost approach to measure assets and liabilities that are measured at fair value. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, accounting standards establish a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1—Financial assets and liabilities whose values are based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.

Level 2—Financial assets and liabilities whose values are based on inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3—Financial assets and liabilities whose values are based on inputs that are both unobservable and significant to the overall valuation.

The Company's MSRs are measured at fair value on a nonrecurring basis. That is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The Company's MSRs do not trade in an active, open market with readily observable prices. While sales of multifamily MSRs do occur, precise terms and conditions vary with each transaction and are not readily available. Accordingly, the estimated fair value of the Company’s MSRs was developed using discounted cash flow models that calculate the present value of estimated future net servicing income. The model considers contractually specified servicing fees, prepayment assumptions, delinquency rates, late charges, other ancillary revenue, costs to service, and other economic factors. The Company periodically reassesses and adjusts, when necessary, the underlying inputs and assumptions used in the model to reflect observable market conditions and assumptions that a market participant would consider in valuing an MSR asset. MSRs are carried at the lower of amortized cost or fair value.

A description of the valuation methodologies used for assets and liabilities measured at fair value on a recurring basis, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. These valuation methodologies were applied to all of the Company's assets and liabilities carried at fair value on a recurring basis:

Derivative Instruments—The derivative instruments used by the Company consist of interest rate lock commitments (“IRLC”), forward sale agreements (“forwards”), interest rate swaps “(IRS”), and, on occasion, synthetic credit default swap index contracts (“CMBX”). The IRLCs and forwards are valued using a discounted cash flow model developed based on changes in the U.S. Treasury rate and other observable market data. The value was determined after considering the potential impact of collateralization, adjusted to reflect nonperformance risk of both the counterparty and the Company, and are classified within Level 3 of the valuation hierarchy. CMBX are traded on an active market with prices determined based on observable inputs such as credit curves, recovery rates, and current credit spreads obtained from market participants. IRS trade in the over-the-counter market where quoted prices are not available. Therefore, the Company uses internal valuation techniques with observable inputs from a liquid market, the most significant of which is the related yield curve, to estimate the fair value of interest rate swaps. There were no CMBX outstanding as of June 30, 2016 as the positions were closed just prior to the end of the first quarter of 2016. During the rest of the first quarter of 2016, the Company had CMBX with a $25.0 million notional amount outstanding. The Company classifies IRS and CMBX as Level 2.

Loans Held for Sale—The loans held for sale are reported at fair value as the Company has elected the fair value option for all loans held for sale. The Company determines the fair value of the loans held for sale intended to be sold to the GSEs and HUD using discounted cash flow models that incorporate quoted observable prices from market participants. The Company determines the fair value of the loans held for sale intended to be sold under a CMBS execution using a hypothetical securitization model utilizing market data from recent securitization spreads and pricing of loans with similar characteristics. As necessary, these fair values are adjusted for typical securitization activities, including portfolio composition, market conditions, and liquidity. The Company classifies all loans held for sale as Level 2.

Pledged Securities—The pledged securities are valued using quoted market prices from recent trades. Therefore, the Company classifies pledged securities as Level 1.

The following table summarizes financial assets and financial liabilities measured at fair value on a recurring basis as of June 30, 2016, and December 31, 2015, segregated by the level of the valuation inputs within the fair value hierarchy used to measure fair value:


	Quoted Prices in		Significant		Significant
	Active Markets		Other		Other
	For Identical		Observable		Unobservable
	Assets		Inputs		Inputs		Balance as of
(in thousands)	(Level 1)		(Level 2)		(Level 3)		Period End
June 30, 2016
Assets
Loans held for sale	$	—	$	2,244,329	$	—	$	2,244,329
Pledged securities		78,491		—		—		78,491
Derivative assets		—		—		28,358		28,358
Total	$	78,491	$	2,244,329	$	28,358	$	2,351,178

Liabilities
Derivative liabilities	$	—	$	1,725	$	27,758	$	29,483
Total	$	—	$	1,725	$	27,758	$	29,483

December 31, 2015
Assets
Loans held for sale	$	—	$	2,499,111	$	—	$	2,499,111
Pledged securities		72,190		—		—		72,190
Derivative assets		—		—		11,678		11,678
Total	$	72,190	$	2,499,111	$	11,678	$	2,582,979

Liabilities
Derivative liabilities	$	—	$	—	$	1,333	$	1,333
Total	$	—	$	—	$	1,333	$	1,333

There were no transfers between any of the levels within the fair value hierarchy during the six months ended June 30, 2016.

Derivative instruments (Level 3) are outstanding for short periods of time (generally less than 60 days). A roll forward of derivative instruments is presented below for the three and six months ended June 30, 2016 and 2015:


	Fair Value Measurements
	Using Significant Unobservable Inputs:
	Derivative Instruments
	For the three months ended				For the six months ended
	June 30,				June 30,
(in thousands)	2016		2015		2016		2015
Derivative assets and liabilities, net
Beginning balance	$	9,578	$	23,674	$	10,345	$	9,658
Settlements		(108,769)		(69,713)		(157,928)		(128,417)
Realized gains recorded in earnings (1)		99,191		46,039		147,583		118,759
Unrealized gains recorded in earnings (1)		600		23,911		600		23,911
Ending balance	$	600	$	23,911	$	600	$	23,911

(1)

Realized and unrealized gains from derivatives are recognized in Gains from mortgage banking activities in the Condensed Consolidated Statements of Income.

The following table presents information about significant unobservable inputs used in the measurement of the fair value of the Company’s Level 3 assets and liabilities as of June 30, 2016:


	Quantitative Information about Level 3 Measurements
(in thousands)	Fair Value		Valuation Technique	Unobservable Input (1)	Input Value (1)
Derivative assets	$	28,358	Discounted cash flow	Counterparty credit risk	—
Derivative liabilities	$	27,758	Discounted cash flow	Counterparty credit risk	—

(1)

Significant increases in this input may lead to significantly lower fair value measurements.

The carrying amounts and the fair values of the Company's financial instruments as of June 30, 2016 and December 31, 2015 are presented below:


	June 30, 2016				December 31, 2015
	Carrying		Fair		Carrying		Fair
(in thousands)	Amount		Value		Amount		Value
Financial assets:
Cash and cash equivalents	$	60,993	$	60,993	$	136,988	$	136,988
Restricted cash		17,611		17,611		5,306		5,306
Pledged securities		78,491		78,491		72,190		72,190
Loans held for sale		2,244,329		2,244,329		2,499,111		2,499,111
Loans held for investment, net		239,861		242,092		231,493		233,370
Derivative assets		28,358		28,358		11,678		11,678
Total financial assets	$	2,669,643	$	2,671,874	$	2,956,766	$	2,958,643

Financial liabilities:
Derivative liabilities	$	29,483	$	29,483	$	1,333	$	1,333
Warehouse notes payable		2,336,925		2,339,241		2,649,470		2,652,011
Note payable		164,313		167,879		164,462		168,431
Total financial liabilities	$	2,530,721	$	2,536,603	$	2,815,265	$	2,821,775

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents and Restricted Cash—The carrying amounts, at face value or cost plus accrued interest, approximate fair value because of the short maturity of these instruments (Level 1).

Pledged Securities—Consist of highly liquid investments in commercial paper of AAA rated entities, investments in money market accounts invested in government securities, and investments in government guaranteed securities. Investments typically have maturities of 90 days or less and are valued using quoted market prices from recent trades.

Loans Held For Sale—Consist of originated loans that are generally transferred or sold within 60 days from the date that the mortgage loan is funded and are valued using (i) discounted cash flow models that incorporate observable prices from market participants or (ii) a hypothetical securitization model utilizing market data from recent securitization spreads and pricing of loans with similar characteristics.

Loans Held For Investment—Consist of originated interim loans which the Company expects to hold for investment for the term of the loan, which is three years or less, and are valued using discounted cash flow models that incorporate primarily observable inputs from market participants and also credit-related adjustments, if applicable (Level 3). As of June 30, 2016 and December 31, 2015, no credit-related adjustments were required.

Derivative Instruments—Consist of IRLCs, forwards, and IRS. IRLCs and forwards are valued using discounted cash flow models developed based on changes in the U.S. Treasury rate and other observable market data. The value is determined after considering the potential impact of collateralization, adjusted to reflect nonperformance risk of both the counterparty and the Company. The fair value of IRS is based on an internal valuation model with observable inputs from an active market.

Warehouse Notes Payable—Consist of borrowings outstanding under warehouse line agreements. The borrowing rates on the warehouse lines are based upon 30-day LIBOR plus a margin. The unpaid principal balance of warehouse notes payable approximates fair value because of the short maturity of these instruments and the monthly resetting of the index rate to prevailing market rates (Level 2).

Note Payable—Consists of borrowings outstanding under a term note agreement. The borrowing rate on the note payable is based upon 30-day LIBOR plus an applicable margin. The Company estimates the fair value by discounting the future cash flows at market rates (Level 2).

Fair Value of Derivative Instruments and Loans Held for Sale—In the normal course of business, the Company enters into contractual commitments to originate and sell multifamily GSE and HUD mortgage loans at fixed prices with fixed expiration dates. The commitments become effective when the borrowers "lock-in" a specified interest rate within time frames established by the Company. All mortgagors are evaluated for creditworthiness prior to the extension of the commitment. Market risk arises if interest rates move adversely between the time of the "lock-in" of rates by the borrower and the sale date of the loan to an investor.

To mitigate the effect of the interest rate risk inherent in providing IRLCs to borrowers for GSE and HUD loans, the Company's policy is to enter into a sale commitment with the investor simultaneous with the rate lock commitment with the borrower. The sale contract with the investor locks in an interest rate and price for the sale of the loan. The terms of the contract with the investor and the rate lock with the borrower are matched in substantially all respects, with the objective of eliminating interest rate risk to the extent practical. Forwards with the investors have an expiration date that is longer than our related IRLCs to the borrower to allow, among other things, for the closing of the loan and processing of paperwork to deliver the loan into the sale commitment.

With respect to the Company’s loans held for sale intended to be sold under a CMBS execution, the Company is exposed to interest rate risk and credit risk (i.e., the risk that investor spreads will change due to perceived credit risk in CMBS loans). To mitigate the interest-rate risk, the Company’s policy is to execute IRS with large national banks. On occasion, the Company executes CMBX with large national banks to mitigate the credit risk.

The IRLCs, forwards, and IRS are undesignated derivatives and, accordingly, are recorded at fair value through Gains on mortgage banking activities in the Condensed Consolidated Statements of Income. The fair value of the Company's IRLCs and loans held for sale and the related input levels includes, as applicable:

the assumed gain/loss of the expected resultant loan sale to the investor (Level 2);

the expected net cash flows associated with servicing the loan (Level 2);

the effects of interest rate movements between the date of the rate lock and the balance sheet date (Level 2); and

the nonperformance risk of both the counterparty and the Company (IRLCs and forwards only; Level 3).

The fair value of the Company's forwards and IRS considers effects of interest rate movements between the trade date and the balance sheet date (Level 2). The market price changes are multiplied by the notional amount of the forwards and IRS to measure the fair value.

The assumed gain/loss considers the amount that the Company has discounted the price to the borrower from par for competitive reasons, if at all, and the expected net cash flows from servicing to be received upon sale of the loan (Level 2). The fair value of the expected net cash flows associated with servicing the loan is calculated pursuant to the valuation techniques applicable to MSRs (Level 2).

To calculate the effects of interest rate movements, the Company uses applicable published U.S. Treasury prices, and multiplies the price movement between the rate lock date or loan origination date and the balance sheet date by the notional loan commitment amount (Level 2).

The fair value of the Company's forwards considers the market price movement of the same type of security between the trade date and the balance sheet date (Level 2). The market price changes are multiplied by the notional amount of the forwards to measure the fair value.

The fair value of the Company’s IRLCs and forwards is adjusted to reflect the risk that the agreement will not be fulfilled. The Company’s exposure to nonperformance in IRLCs and forwards is represented by the contractual amount of those instruments. Given the credit quality of our counterparties and the short duration of IRLCs and forwards, the risk of nonperformance by the Company’s counterparties has historically not been significant (Level 3).

The following table presents the components of fair value and other relevant information associated with the Company’s derivative instruments and loans held for sale as of June 30, 2016 and December 31, 2015.


			Fair Value Adjustment Components						Balance Sheet Location
													Fair Value
	Notional or		Assumed		Interest Rate		Total						Adjustment
	Principal		Gain		Movement or		Fair Value		Derivative		Derivative		To Loans
(in thousands)	Amount		on Sale		Other Effect		Adjustment		Assets		Liabilities		Held for Sale
June 30, 2016
Rate lock commitments	$	627,317	$	19,144	$	8,725	$	27,869	$	27,869	$	—	$	—
Forward sale contracts		2,761,496		—		(27,269)		(27,269)		489		(27,758)		—
Interest rate swaps		34,460		—		(1,725)		(1,725)		—		(1,725)		—
Loans held for sale		2,181,494		41,652		21,183		62,835		—		—		62,835
Total			$	60,796	$	914	$	61,710	$	28,358	$	(29,483)	$	62,835

December 31, 2015
Rate lock commitments	$	267,710	$	9,467	$	(1,494)	$	7,973	$	7,973	$	—	$	—
Forward sale contracts		2,747,590		—		2,371		2,371		3,705		(1,333)		—
Loans held for sale		2,479,880		20,108		(877)		19,231		—		—		19,231
Total			$	29,575	$	—	$	29,575	$	11,678	$	(1,333)	$	19,231