Note 7 - Fair Value of Financial Instruments

3 Months Ended

Mar. 31, 2013

Fair Value Disclosures [Text Block]

Note 7 – Fair Value of Financial Instruments

Our valuation techniques for financial instruments are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from third-party sources, while unobservable inputs reflect management’s market assumptions. The ASC Topic No. 820 “Fair Value Measurement” classifies these inputs into the following hierarchy:

Level 1 Inputs - Quoted prices for identical instruments in active markets.

Level 2 Inputs - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3 Inputs - Prices determined using significant unobservable inputs. Unobservable inputs may be used in situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment at the end of the period). Unobservable inputs reflect management’s assumptions about the factors that market participants would use in pricing an asset or liability, and would be based on the best information available.

The following describes the valuation methodologies used for our assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy. Any transfers between levels are assumed to occur at the beginning of the reporting period.

Cash - Cash includes cash on deposit with financial institutions. The carrying amount of cash is deemed to be its fair value and is classified as Level 1. Cash balances posted or held by counterparties as collateral are classified as Level 2

  Agency Securities Available for Sale - Fair value for the Agency Securities in our portfolio is based on obtaining a valuation for each Agency Security from third-party pricing services and dealer quotes. The third-party pricing services use common market pricing methods that may include pricing models that may incorporate such factors as coupons, prepayment speeds, spread to the Treasury curves and interest rate swap curves, duration, periodic and life caps and credit enhancement. If the fair value of a security is not available from the third-party pricing services or such data appears unreliable, we obtain valuations from up to three dealers who make markets in similar financial instruments. In general, the dealers incorporate common market pricing methods, including a spread measurement to the Treasury curve or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, collateral type, rate reset period and seasoning or age of the security. Management reviews pricing used to ensure that current market conditions are properly represented. This review includes, but is not limited to, comparisons of similar market transactions or alternative third-party pricing services, dealer quotes and comparisons to a pricing model. Values obtained from the third-party pricing services for similar instruments are classified as Level 2 securities if the pricing methods used are consistent with the Level 2 definition. If quoted prices for a security are not reasonably available from the pricing service, but dealer quotes are, the security will be classified as a Level 2 security. If neither is available, management will determine the fair value based on characteristics of the security that we receive from the issuer and based on available market information received from dealers and classify it as a Level 3 security. As of March 31, 2013 and December 31, 2012, all of our Agency Security values are based solely on third-party sources and therefore were classified as Level 2.

Non-Agency Securities Trading - The fair value for the Non-Agency Securities in our portfolio is based on estimates prepared by our Portfolio Management group, which organizationally reports to our Chief Investment Officer.  In preparing the estimates, the Portfolio Management group uses commercially available and proprietary models and data as well as market intelligence gained from discussions with and transactions by other market participants.  We also periodically compare our estimates of fair value with those of our financing counterparties. We estimate the fair value of our Non-Agency Securities by estimating the future cash flows for each Non-Agency Security and then discounting those cash flows based on our estimates of current market yield for each individual security. Our estimates for future cash flows and current market yields incorporate such factors as collateral type, bond structure and priority of payments, coupons, prepayment speeds, defaults, delinquencies and severities. We compare our estimates of fair value of our Non-Agency Securities with pricing from third-party pricing services and dealer marks received to validate our assumptions of cash flow and market yield.  Fair values calculated in this manner are considered Level 3.

Repurchase Agreements - The fair value of repurchase agreements reflects the present value of the contractual cash flows discounted at the estimated LIBOR based 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, of our repurchase agreements. The fair value of the repurchase agreements approximates their carrying amount due to the short-term nature of these financial instruments. Our repurchase agreements are classified as Level 2.

Derivative Transactions - The fair values of our interest rate swap contracts and interest rate swaptions are valued using third-party pricing services that incorporate common market pricing methods that may include current interest rate curves, forward interest rate curves and market spreads to interest rate curves. Management compares pricing used to dealer quotes to ensure that the current market conditions are properly represented. The fair values of our interest rate swap contracts and our interest rate swaptions are classified as Level 2.

The following tables provide a summary of our assets and liabilities that are measured at fair value on a recurring basis as of March 31, 2013 and December 31, 2012.

	Quoted Prices in Active Markets for Identical Assets  (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance at March 31, 2013
	(in thousands)
Assets at Fair Value:
Agency Securities, available for sale	$	-	$	1,078,281	$	-	$	1,078,281
Non-Agency Securities, trading		-		-		136,752		136,752
Derivatives		-		7,666		-		7,666
Liabilities at Fair Value:
Derivatives	$	-	$	597	$	-	$	597

	Quoted Prices in Active Markets for Identical Assets  (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance at December 31, 2012
	(in thousands)
Assets at Fair Value:
Agency Securities, available for sale	$	-	$	1,112,358	$	-	$	1,112,358
Non-Agency Securities, trading		-		-		129,946		129,946
Derivatives		-		4,940		-		4,940
Liabilities at Fair Value:
Derivatives	$	-	$	365	$	-	$	365

The following tables provide a summary of the carrying values and fair values of our financial assets and liabilities not carried at fair value on a recurring basis as of March 31, 2013 and December 31, 2012.

	At March 31, 2013				Fair Value Measurements using:
	Carrying Value		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Financial Assets:
Cash	$	28,060	$	28,060	$	28,060	$	-	$	-
Cash collateral posted		547		547				547
Accrued interest receivable		2,713		2,713		-		2,713		-
Financial Liabilities:
Repurchase agreements	$	1,108,942	$	1,108,942	$	-	$	1,108,942	$	-
Cash collateral held		5,782		5,782		-		5,782		-
Accrued interest payable		736		736		-		736		-

	At December 31, 2012				Fair Value Measurements using:
	Carrying Value		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Financial Assets:
Cash	$	36,316	$	36,316	$	36,316	$	-	$	-
Cash collateral posted		273		273				273
Accrued interest receivable		2,759		2,759		-		2,759		-
Financial Liabilities:
Repurchase agreements	$	1,135,830	$	1,135,830	$	-	$	1,135,830	$	-
Cash collateral held		1,426		1,426		-		1,426		-
Accrued interest payable		844		844		-		844		-

The following table provides a summary of the changes in Level 3 assets and liabilities measured at fair value on a recurring basis as of March 31, 2013.

	March 31, 2013
	(in thousands)
Balance, beginning of period	$	129,946
Purchase of securities, at cost		9,757
Principal repayments		(4,875	)
Net gain		2,210
Discount accretion		(286	)
Balance, end of period	$	136,752
Net gains for outstanding Level 3 Assets	$	2,210

The significant unobservable inputs used in the fair value measurement of our Level 3 Non-Agency Securities include assumptions for underlying loan collateral default rates and loss severities in the event of default, as well as discount rates.

The following tables present the range of our estimates of cumulative default and loss severities, together with the discount rates implicit in our Level 3 Non-Agency Security fair values totaling $136.8 million and $129.9 million as of March 31, 2013 and December 31, 2012.

March 31, 2013

Unobservable Level 3 Input	Minimum			Weighted Average			Maximum
Cumulative default		6.04	%		17.24	%		24.67	%
Loss Severity (Life)		35.50			47.92			60.20
Discount rate		4.25			4.51			4.76

December 31, 2012

Unobservable Level 3 Input	Minimum			Weighted Average			Maximum
Cumulative default		6.28	%		17.65	%		26.26	%
Loss Severity (Life)		36.70			48.52			56.00
Discount rate		4.50			5.17			5.54

Significant increases or decreases in any of these inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates. However, given the interrelationship between loss estimates and the discount rate, overall Non-Agency Security market conditions would likely have a more significant impact on our Level 3 fair values than changes in any one unobservable input.