Note 6—Fair Value

Most of the Company’s assets and certain of its liabilities are measured based on their fair values. The application of fair value may be on a recurring or nonrecurring basis depending on the accounting principles applicable to the specific asset or liability and whether management has elected to carry the item at its fair value as discussed in the following paragraphs.

The Company groups its assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the observability of the inputs used to determine fair value. These levels are:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Prices determined or determinable using other significant observable inputs. Observable inputs are inputs that other market participants would use in pricing an asset or liability and are developed based on market data obtained from sources independent of the Company. These may include quoted prices for similar assets and liabilities, interest rates, prepayment speeds, credit risk and other inputs.

Level 3—Prices determined using significant unobservable inputs. In situations where observable inputs are unavailable, unobservable inputs may be used. Unobservable inputs reflect the Company’s own judgments about the factors that market participants use in pricing an asset or liability, and are based on the best information available in the circumstances.

As a result of the difficulty in observing certain significant valuation inputs affecting “Level 3” fair value assets and liabilities, the Company is required to make judgments regarding these items’ fair values. Different persons in possession of the same facts may reasonably arrive at different conclusions as to the inputs to be applied in valuing these assets and liabilities and their fair values. Such differences may result in significantly different fair value measurements. Likewise, due to the general illiquidity of some of these assets and liabilities, subsequent transactions may be at values significantly different from those reported.

Fair Value Accounting Elections

The Company identified all of its non-cash financial assets, other than Assets purchased from PennyMac Mortgage Investment Trust under agreements to resell and Mortgage servicing liabilities (“MSLs”) to be accounted for at fair value so changes in fair value will be reflected in income as they occur and more timely reflect the results of the Company’s performance. Beginning January 1, 2018, the Company accounts for all MSRs at fair value. Before January 1, 2018, originated MSRs backed by mortgage loans with initial interest rates of less than or equal to 4.5% were accounted for using the amortization method. The Company elected to account for all MSRs at fair value because management determined that this change makes the accounting treatment for MSRs consistent with lender valuation under financing arrangements and simplifies hedging activities. The Company has also identified its ESS to be accounted for at fair value as a means of hedging the related MSRs’ fair value risk.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Following is a summary of assets and liabilities that are measured at fair value on a recurring basis:


	September 30, 2018
	Level 1		Level 2		Level 3		Total
	(in thousands)
Assets:
Short-term investments	$	145,476	$	—	$	—	$	145,476
Mortgage loans held for sale at fair value		—		2,051,652		365,303		2,416,955
Derivative assets:
Interest rate lock commitments		—		—		41,075		41,075
Repurchase agreement derivatives		—		—		26,475		26,475
Forward purchase contracts		—		821		—		821
Forward sales contracts		—		16,892		—		16,892
MBS put options		—		4,413		—		4,413
MBS call options		—		12		—		12
Put options on interest rate futures purchase contracts		3,063		—		—		3,063
Call options on interest rate futures purchase contracts		63		—		—		63
Total derivative assets before netting		3,126		22,138		67,550		92,814
Netting		—		—		—		(19,196)
Total derivative assets		3,126		22,138		67,550		73,618
Investment in PennyMac Mortgage Investment Trust		1,518		—		—		1,518
Mortgage servicing rights at fair value		—		—		2,785,964		2,785,964
	$	150,120	$	2,073,790	$	3,218,817	$	5,423,531
Liabilities:
Excess servicing spread financing payable to PennyMac Mortgage Investment Trust at fair value	$	—	$	—	$	223,275	$	223,275
Derivative liabilities:
Interest rate lock commitments		—		—		3,912		3,912
Forward purchase contracts		—		29,569		—		29,569
Forward sales contracts		—		2,780		—		2,780
Total derivative liabilities before netting		—		32,349		3,912		36,261
Netting		—		—		—		(23,568)
Total derivative liabilities		—		32,349		3,912		12,693
Mortgage servicing liabilities at fair value		—		—		9,769		9,769
	$	—	$	32,349	$	236,956	$	245,737


	December 31, 2017
	Level 1		Level 2		Level 3		Total
	(in thousands)
Assets:
Short-term investments	$	170,080	$	—	$	—	$	170,080
Mortgage loans held for sale at fair value		—		2,316,892		782,211		3,099,103
Derivative assets:
Interest rate lock commitments		—		—		60,012		60,012
Repurchase agreement derivatives		—		—		10,656		10,656
Forward purchase contracts		—		4,288		—		4,288
Forward sales contracts		—		2,101		—		2,101
MBS put options		—		3,481		—		3,481
Put options on interest rate futures purchase contracts		3,570		—		—		3,570
Call options on interest rate futures purchase contracts		938		—		—		938
Total derivative assets before netting		4,508		9,870		70,668		85,046
Netting		—		—		—		(6,867)
Total derivative assets		4,508		9,870		70,668		78,179
Investment in PennyMac Mortgage Investment Trust		1,205		—		—		1,205
Mortgage servicing rights at fair value		—		—		638,010		638,010
	$	175,793	$	2,326,762	$	1,490,889	$	3,986,577
Liabilities:
Excess servicing spread financing payable to PennyMac Mortgage Investment Trust at fair value	$	—	$	—	$	236,534	$	236,534
Derivative liabilities:
Interest rate lock commitments		—		—		1,740		1,740
Forward purchase contracts		—		1,272		—		1,272
Forward sales contracts		—		7,031		—		7,031
Total derivative liabilities before netting		—		8,303		1,740		10,043
Netting		—		—		—		(4,247)
Total derivative liabilities		—		8,303		1,740		5,796
Mortgage servicing liabilities at fair value		—		—		14,120		14,120
	$	—	$	8,303	$	252,394	$	256,450

As shown above, all or a portion of the Company’s mortgage loans held for sale, Interest Rate Lock Commitments (“IRLCs”), repurchase agreement derivatives, MSRs at fair value, ESS at fair value and MSLs are measured using Level 3 fair value inputs. Following are roll forwards of these items for each of the quarters and nine months ended September 30, 2018 and 2017:


	Quarter ended September 30, 2018
	Mortgage		Net interest		Repurchase		Mortgage
	loans held		rate lock		agreement		servicing
	for sale		commitments (1)		derivatives		rights			Total
	(in thousands)
Assets:
Balance, June 30, 2018	$	334,166	$	55,689	$	25,781	$	2,486,157	$	2,901,793
Purchases and issuances, net		1,008,662		41,721		12,903		163,511		1,226,797
Sales and repayments		(231,921)		—		(11,982)		—		(243,903)
Mortgage servicing rights resulting from mortgage loan sales		—		—		—		149,000		149,000
Changes in fair value included in income arising from:
Changes in instrument-specific credit risk		84		—		—		—		84
Other factors		—		10,696		(227)		(12,704)		(2,235)
		84		10,696		(227)		(12,704)		(2,151)
Transfers from Level 3 to Level 2		(744,324)		—		—		—		(744,324)
Transfers to real estate acquired in settlement of loans		(1,364)		—		—		—		(1,364)
Transfers of interest rate lock commitments to mortgage loans held for sale		—		(70,943)		—		—		(70,943)
Balance, September 30, 2018	$	365,303	$	37,163	$	26,475	$	2,785,964	$	3,214,905
Changes in fair value recognized during the quarter relating to assets still held at September 30, 2018	$	(4,811)	$	37,163	$	—	$	(12,704)	$	19,648

(1)

For the purpose of this table, the IRLC asset and liability positions are shown net.


	Quarter ended September 30, 2018
	Excess
	servicing		Mortgage
	spread		servicing
	financing		liabilities		Total
	(in thousands)
Liabilities:
Balance, June 30, 2018	$	229,470	$	10,253	$	239,723
Issuance of excess servicing spread financing pursuant to a recapture agreement with PennyMac Mortgage Investment Trust		499		—		499
Accrual of interest		3,740		—		3,740
Repayments		(11,543)		—		(11,543)
Mortgage servicing liabilities resulting from mortgage loan sales		—		1,741		1,741
Changes in fair value included in income		1,109		(2,225)		(1,116)
Balance, September 30, 2018	$	223,275	$	9,769	$	233,044
Changes in fair value recognized during the quarter relating to liabilities still outstanding at September 30, 2018	$	1,109	$	(2,225)	$	(1,116)


	Quarter ended September 30, 2017
	Mortgage		Net interest		Repurchase		Mortgage
	loans held		rate lock		agreement		servicing
	for sale		commitments (1)		derivatives		rights			Total
	(in thousands)
Assets:
Balance, June 30, 2017	$	380,084	$	46,158	$	—	$	678,441	$	1,104,683
Purchases and issuances, net		499,546		83,798		469		41		583,854
Sales and repayments		(306,458)		—		—		—		(306,458)
Interest rate lock commitments issued, net		—		—		—		—		—
Mortgage servicing rights resulting from mortgage loan sales		—		—		—		5,773		5,773
Changes in fair value included in income arising from:
Changes in instrument-specific credit risk		(1,130)		—		—		—		(1,130)
Other factors		—		41,693		—		(28,271)		13,422
		(1,130)		41,693		—		(28,271)		12,292
Transfers from Level 3 to Level 2		(195,802)		—		—		—		(195,802)
Transfers of interest rate lock commitments to mortgage loans held for sale		—		(117,265)		—		—		(117,265)
Balance, September 30, 2017	$	376,240	$	54,384	$	469	$	655,984	$	1,087,077
Changes in fair value recognized during the quarter relating to assets still held at September 30, 2017	$	(2,851)	$	54,384	$	—	$	(28,271)	$	23,262

(1)

For the purpose of this table, the IRLC asset and liability positions are shown net.


	Quarter ended September 30, 2017
	Excess
	servicing		Mortgage
	spread		servicing
	financing		liabilities		Total
	(in thousands)
Liabilities:
Balance, June 30, 2017	$	261,796	$	18,295	$	280,091
Issuance of excess servicing spread financing pursuant to a recapture agreement with PennyMac Mortgage Investment Trust		1,207		—		1,207
Accrual of interest		3,998		—		3,998
Repayments		(13,410)		—		(13,410)
Mortgage servicing liabilities resulting from mortgage loan sales		—		4,071		4,071
Changes in fair value included in income		(4,828)		(6,290)		(11,118)
Balance, September 30, 2017	$	248,763	$	16,076	$	264,839
Changes in fair value recognized during the quarter relating to liabilities still outstanding at September 30, 2017	$	(4,828)	$	(6,290)	$	(11,118)


	Nine months ended September 30, 2018
	Mortgage		Net interest		Repurchase		Mortgage
	loans held		rate lock		agreement		servicing
	for sale		commitments (1)		derivatives		rights			Total
	(in thousands)
Assets:
Balance, December 31, 2017	$	782,211	$	58,272	$	10,656	$	638,010	$	1,489,149
Reclassification of mortgage servicing rights previously accounted for under the amortization method pursuant to a change in accounting principle		—		—		—		1,482,426		1,482,426
Balance, January 1, 2018		782,211		58,272		10,656		2,120,436		2,971,575
Purchases and issuances, net		2,480,523		157,649		36,624		193,640		2,868,436
Sales and repayments		(1,122,448)		—		(19,460)		—		(1,141,908)
Mortgage servicing rights resulting from mortgage loan sales		—		—		—		448,604		448,604
Changes in fair value included in income arising from:
Changes in instrument-specific credit risk		(4,944)		—		—		—		(4,944)
Other factors		—		(28,627)		(1,345)		23,284		(6,688)
		(4,944)		(28,627)		(1,345)		23,284		(11,632)
Transfers from Level 3 to Level 2		(1,765,854)		—		—		—		(1,765,854)
Transfers to real estate acquired in settlement of loans		(4,185)		—		—		—		(4,185)
Transfers of interest rate lock commitments to mortgage loans held for sale		—		(150,131)		—		—		(150,131)
Balance, September 30, 2018	$	365,303	$	37,163	$	26,475	$	2,785,964	$	3,214,905
Changes in fair value recognized during the period relating to assets still held at September 30, 2018	$	(4,912)	$	37,163	$	—	$	23,284	$	55,535

(1)

For the purpose of this table, the IRLC asset and liability positions are shown net.


	Nine months ended September 30, 2018
	Excess
	servicing		Mortgage
	spread		servicing
	financing		liabilities		Total
	(in thousands)
Liabilities:
Balance, December 31, 2017	$	236,534	$	14,120	$	250,654
Issuance of excess servicing spread financing pursuant to a recapture agreement with PennyMac Mortgage Investment Trust		1,983		—		1,983
Accrual of interest		11,584		—		11,584
Repayments		(35,852)		—		(35,852)
Mortgage servicing liabilities resulting from mortgage loan sales		—		5,548		5,548
Changes in fair value included in income		9,026		(9,899)		(873)
Balance, September 30, 2018	$	223,275	$	9,769	$	233,044
Changes in fair value recognized during the period relating to liabilities still outstanding at September 30, 2018	$	9,026	$	(9,899)	$	(873)


	Nine months ended September 30, 2017
	Mortgage		Net interest		Repurchase		Mortgage
	loans held		rate lock		agreement		servicing
	for sale		commitments (1)		derivatives		rights		Total
	(in thousands)
Assets:
Balance December 31, 2016	$	47,271	$	59,391	$	—	$	515,925	$	622,587
Purchases		1,815,509		226,617		469		183,830		2,226,425
Sales and repayments		(845,318)		—		—		—		(845,318)
Interest rate lock commitments issued, net		—		—		—		—		—
Mortgage servicing rights resulting from mortgage loan sales		—		—		—		19,702		19,702
Changes in fair value included in income arising from:
Changes in instrument-specific credit risk		(6,104)		—		—		—		(6,104)
Other factors		—		99,425		—		(63,473)		35,952
		(6,104)		99,425		—		(63,473)		29,848
Transfers from Level 3 to Level 2		(635,118)		—		—		—		(635,118)
Transfers of interest rate lock commitments to mortgage loans held for sale		—		(331,049)		—		—		(331,049)
Balance, September 30, 2017	$	376,240	$	54,384	$	469	$	655,984	$	1,087,077
Changes in fair value recognized during the year relating to assets still held at September 30, 2017	$	(3,733)	$	54,384	$	—	$	(63,473)	$	(12,822)

(1)

For the purpose of this table, the IRLC asset and liability positions are shown net.


	Nine months ended September 30, 2017
	Excess
	servicing		Mortgage
	spread		servicing
	financing		liabilities		Total
	(in thousands)
Liabilities:
Balance December 31, 2016	$	288,669	$	15,192	$	303,861
Issuance of excess servicing spread financing pursuant to a recapture agreement with PennyMac Mortgage Investment Trust		4,160		—		4,160
Accrual of interest		13,011		—		13,011
Repayments		(42,320)		—		(42,320)
Mortgage servicing liabilities resulting from mortgage loan sales		—		11,940		11,940
Mortgage servicing liabilities assumed		—		—		—
Changes in fair value included in income		(14,757)		(11,056)		(25,813)
Balance, September 30, 2017	$	248,763	$	16,076	$	264,839
Changes in fair value recognized during the year relating to liabilities still outstanding at September 30, 2017	$	(14,757)	$	(11,056)	$	(25,813)

The information used in the preceding roll forwards represents activity for assets and liabilities measured at fair value on a recurring basis and identified as using “Level 3” significant fair value inputs at either the beginning or the end of the periods presented. The Company had transfers among the fair value levels arising from transfers of IRLCs to mortgage loans held for sale at fair value upon purchase or funding of the respective mortgage loans and from the return to salability in the active secondary market of certain mortgage loans held for sale.

Assets and Liabilities Measured at Fair Value under the Fair Value Option

Net changes in fair values included in income for assets and liabilities carried at fair value as a result of management’s election of the fair value option by income statement line item are summarized below:


	Quarter ended September 30,
	2018						2017
	Net		Net gains on				Net		Net gains on
	mortgage		mortgage				mortgage		mortgage
	loan		loans held				loan		loans held
	servicing		for sale at				servicing		for sale at
	fees		fair value		Total		fees		fair value		Total
	(in thousands)
Assets:
Mortgage loans held for sale at fair value	$	—	$	67,709	$	67,709	$	—	$	130,869	$	130,869
Mortgage servicing rights at fair value		(12,704)		—		(12,704)		(28,271)		—		(28,271)
	$	(12,704)	$	67,709	$	55,005	$	(28,271)	$	130,869	$	102,598
Liabilities:
Excess servicing spread financing at fair value payable to PennyMac Mortgage Investment Trust	$	(1,109)	$	—	$	(1,109)	$	4,828	$	—	$	4,828
Mortgage servicing liabilities at fair value		2,225		—		2,225		6,290		—		6,290
	$	1,116	$	—	$	1,116	$	11,118	$	—	$	11,118


	Nine months ended September 30,
	2018						2017
	Net		Net gains on				Net		Net gains on
	mortgage		mortgage				mortgage		mortgage
	loan		loans held				loan		loans held
	servicing		for sale at				servicing		for sale at
	fees		fair value		Total		fees		fair value		Total
	(in thousands)
Assets:
Mortgage loans held for sale at fair value	$	—	$	118,452	$	118,452	$	—	$	336,836	$	336,836
Mortgage servicing rights at fair value		23,284		—		23,284		(63,473)		—		(63,473)
	$	23,284	$	118,452	$	141,736	$	(63,473)	$	336,836	$	273,363
Liabilities:
Excess servicing spread financing at fair value payable to PennyMac Mortgage Investment Trust	$	(9,026)	$	—	$	(9,026)	$	14,757	$	—	$	14,757
Mortgage servicing liabilities at fair value		9,899		—		9,899		11,056		—		11,056
	$	873	$	—	$	873	$	25,813	$	—	$	25,813

Following are the fair value and related principal amounts due upon maturity of assets accounted for under the fair value option:


	September 30, 2018						December 31, 2017
			Principal						Principal
			amount						amount
	Fair		due upon				Fair		due upon
	value		maturity		Difference		value		maturity		Difference
	(in thousands)
Mortgage loans held for sale:
Current through 89 days delinquent	$	2,148,919	$	2,078,047	$	70,872	$	2,430,517	$	2,326,772	$	103,745
90 days or more delinquent:
Not in foreclosure		215,712		218,623		(2,911)		614,329		614,357		(28)
In foreclosure		52,324		56,101		(3,777)		54,257		57,248		(2,991)
	$	2,416,955	$	2,352,771	$	64,184	$	3,099,103	$	2,998,377	$	100,726

Assets Measured at Fair Value on a Nonrecurring Basis

Following is a summary of assets and liabilities that were measured at fair value on a nonrecurring basis during the periods presented:


	September 30, 2018
	Level 1		Level 2		Level 3		Total
	(in thousands)
Real estate acquired in settlement of loans	$	—	$	—	$	2,134	$	2,134


	December 31, 2017
	Level 1		Level 2		Level 3		Total
	(in thousands)
Mortgage servicing rights at lower of amortized cost or fair value	$	—	$	—	$	1,463,552	$	1,463,552
Real estate acquired in settlement of loans		—		—		2,355		2,355
	$	—	$	—	$	1,465,907	$	1,465,907

The following table summarizes the total gains (losses) on assets measured at fair value on a nonrecurring basis:


	Quarter ended September 30,				Nine months ended September 30,
	2018		2017		2018		2017
	(in thousands)
Mortgage servicing rights at lower of amortized cost or fair value	$	—	$	(17,270)	$	—	$	(33,906)
Real estate acquired in settlement of loans		(41)		17		(72)		102
	$	(41)	$	(17,253)	$	(72)	$	(33,804)

Fair Value of Financial Instruments Carried at Amortized Cost

The Company’s Assets purchased from PennyMac Mortgage Investment Trust under agreements to resell, Assets sold under agreements to repurchase, Mortgage loan participation purchase and sale agreements, Notes payable, and Obligations under capital lease are carried at amortized cost. These assets and liabilities’ fair values do not have observable inputs and the fair value is measured using management’s estimate of fair value. Accordingly, the Company has classified these financial instruments as “Level 3” fair value assets and liabilities. The Company has concluded that those assets and liabilities’ fair values approximate the carrying value due to their short terms and/or variable interest rates.

Valuation Governance

Most of the Company’s financial assets, and all of its MSRs, ESS, derivative liabilities and MSLs, are carried at fair value with changes in fair value recognized in current period income. Certain of the Company’s financial assets and all of its MSRs, ESS and MSLs are “Level 3” fair value assets and liabilities which require the use of unobservable inputs that are significant to the estimation of the items’ fair values. Unobservable inputs reflect the Company’s own judgments about the factors that market participants use in pricing an asset or liability, and are based on the best information available under the circumstances.

Due to the difficulty in estimating the fair values of “Level 3” fair value assets and liabilities, management has assigned the responsibility for estimating the fair value of these items to specialized staff and subjects the valuation process to significant senior management oversight. The Company’s Financial Analysis and Valuation group (the “FAV group”) is the Company’s specialized staff responsible for estimating the fair values of “Level 3” fair value assets and liabilities other than IRLCs.

With respect to the non-IRLC “Level 3” valuations, the FAV group reports to the Company’s senior management valuation committee, which oversees the valuations. The FAV group monitors the models used for valuation of the Company’s “Level 3” fair value assets and liabilities, including the models’ performance versus actual results, and reports those results to the Company’s senior management valuation committee. The Company’s senior management valuation committee includes the Company’s executive chairman, chief executive, chief financial, chief risk and deputy chief financial officers.

The FAV group is responsible for reporting to the Company’s senior management valuation committee on the changes in the valuation of the non-IRLC “Level 3” fair value assets and liabilities, including major factors affecting the valuation and any changes in model methods and inputs. To assess the reasonableness of its valuations, the FAV group presents an analysis of the effect on the valuation of changes to the significant inputs to the models.

With respect to IRLCs, the Company has assigned responsibility for developing fair values to its Capital Markets Risk Management staff. The fair values developed by the Capital Markets Risk Management staff are reviewed by the Company’s Capital Markets Operations group.

Valuation Techniques and Inputs

Following is a description of the techniques and inputs used in estimating the fair values of “Level 2” and “Level 3” fair value assets and liabilities:

Mortgage Loans Held for Sale

Most of the Company’s mortgage loans held for sale at fair value are saleable into active markets and are therefore categorized as “Level 2” fair value assets and their fair values are determined using their quoted market or contracted selling price or market price equivalent.

Certain of the Company’s mortgage loans held for sale are not saleable into active markets and are therefore categorized as “Level 3” fair value assets. Mortgage loans held for sale categorized as “Level 3” fair value assets include:

Certain delinquent government guaranteed or insured mortgage loans purchased by the Company from Ginnie Mae guaranteed pools in its mortgage loan servicing portfolio. The Company’s right to purchase delinquent government guaranteed or insured mortgage loans arises as the result of the borrower’s failure to make payments for at least three consecutive months preceding the month of repurchase by the Company and provides an alternative to the Company’s obligation to continue advancing principal and interest at the coupon rate of the related Ginnie Mae security. Such repurchased mortgage loans may be resold to third-party investors and thereafter may be repurchased to the extent they become eligible for resale into a new Ginnie Mae guaranteed pool. Government guaranteed mortgage loans generally become eligible for resale when the repurchased mortgage loans become current either through the borrower’s reperformance or through completion of a modification of the mortgage loan’s terms.

Certain of the Company’s mortgage loans held for sale that become non-saleable into active markets due to identification of a defect by the Company or to the repurchase by the Company of a mortgage loan with an identified defect.

The Company uses a discounted cash flow model to estimate the fair value of its “Level 3” fair value mortgage loans held for sale at fair value. The significant unobservable inputs used in the fair value measurement of the Company’s “Level 3” fair value mortgage loans held for sale at fair value are discount rates, home price projections, voluntary prepayment/resale speeds and total prepayment speeds. Significant changes in any of those inputs in isolation could result in a significant change to the mortgage loans’ fair value measurement. Increases in home price projections are generally accompanied by an increase in voluntary prepayment speeds.

Following is a quantitative summary of key “Level 3” fair value inputs used in the valuation of mortgage loans held for sale at fair value:



Key inputs (1)	September 30, 2018	December 31, 2017
Discount rate:
Range	2.8% – 9.2%	2.9% – 10.0%
Weighted average	2.9%	2.9%
Twelve-month projected housing price index change:
Range	3.5% – 6.1%	3.1% – 5.6%
Weighted average	3.9%	3.6%
Voluntary prepayment / resale speed (2):
Range	0.1% – 71.0%	0.2% – 72.2%
Weighted average	24.2%	44.6%
Total prepayment speed (3):
Range	0.1% – 72.1%	0.2% – 75.2%
Weighted average	41.3%	55.8%

(1)

Weighted average inputs are based on fair value of mortgage loans.

(2)

Voluntary prepayment/resale speed is measured using Life Voluntary Conditional Prepayment Rate (“CPR”).

(3)

Total prepayment speed is measured using Life Total CPR.

Changes in fair value attributable to changes in instrument specific credit risk are measured by reference to the change in the respective mortgage loan’s delinquency status and performance history at period end from the later of the beginning of the period or acquisition date. Changes in fair value of mortgage loans held for sale are included in Net gains on mortgage loans held for sale at fair value in the Company’s consolidated statements of income.

Derivative Financial Instruments

Interest Rate Lock Commitments

The Company categorizes IRLCs as a “Level 3” fair value asset or liability. The Company estimates the fair value of an IRLC based on quoted Agency MBS prices, its estimate of the fair value of the MSRs it expects to receive in the sale of the mortgage loans and the probability that the mortgage loan will fund or be purchased (the “pull-through rate”).

The significant unobservable inputs used in the fair value measurement of the Company’s IRLCs are the pull-through rate and the MSR component of the Company’s estimate of the fair value of the mortgage loans it has committed to purchase. Significant changes in the pull-through rate or the MSR component of the IRLCs, in isolation, could result in significant changes in the IRLCs’ fair value measurement. The financial effects of changes in these inputs are generally inversely correlated as increasing interest rates have a positive effect on the fair value of the MSR component of IRLC fair value, but increase the pull-through rate for the mortgage loan principal and interest payment cash flow component, which has decreased in fair value.

Changes in fair value of IRLCs are included in Net gains on mortgage loans acquired for sale at fair value and may be allocated to Net mortgage loan servicing fees – Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities as an economic hedge of the fair value of MSRs in the consolidated statements of income when it is included as a component of the Company’s MSR hedging strategy.

Following is a quantitative summary of key “Level 3” fair value inputs used in the valuation of IRLCs:



Key inputs (1)	September 30, 2018	December 31, 2017
Pull-through rate:
Range	16.6% – 100%	25.0% – 100%
Weighted average	85.7%	85.6%
Mortgage servicing rights value expressed as:
Servicing fee multiple:
Range	1.6 – 5.9	1.4 – 5.8
Weighted average	4.0	4.0
Percentage of unpaid principal balance:
Range	0.4% – 2.8%	0.3% – 3.0%
Weighted average	1.4%	1.4%

(1)

Weighted average inputs are based on notional amount of IRLCs.

Hedging Derivatives

Fair value of exchange-traded hedging derivative financial instruments are categorized by the Company as “Level 1” fair value assets and liabilities. Fair value of hedging derivative financial instruments based on observable MBS prices or interest rate volatilities in the MBS market are categorized as “Level 2” fair value assets and liabilities.

Changes in the fair value of hedging derivatives are included in Net gains on mortgage loans acquired for sale at fair value, or Net mortgage loan servicing fees – Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities, as applicable, in the consolidated statements of income.

Repurchase Agreement Derivatives

The Company has a master repurchase agreement that includes incentives for financing mortgage loans approved for satisfying certain consumer relief characteristics. These incentives are classified for financial reporting purposes as embedded derivatives and are accounted for separate from the master repurchase agreement. The Company classifies these derivatives as “Level 3” fair value assets. The significant unobservable inputs into the valuation of these derivative assets are the discount rate and the Company’s expected approval rate of the mortgage loans financed under the master repurchase agreement. The resulting ratio included in the Company’s fair value estimate was 97% at September 30, 2018 and December 31, 2017.

Changes in fair value of repurchase agreement derivatives are included in Interest expense in the consolidated statements of income.

Mortgage Servicing Rights

MSRs are categorized as “Level 3” fair value assets. The Company uses a discounted cash flow approach to estimate the fair value of MSRs. The key inputs used in the estimation of the fair value of MSRs include prepayment and default rates of the underlying mortgage loans, the applicable pricing spread and annual per-loan cost to service mortgage loans, all of which are unobservable. Significant changes to any of those inputs in isolation could result in a significant change in the MSR fair value measurement. Changes in these key inputs are not necessarily directly related. Recognized changes in the fair value of MSRs are included in Net mortgage loan servicing fees—Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities in the consolidated statements of income.

MSRs are generally subject to loss in fair value when mortgage interest rates decrease. Decreasing mortgage interest rates normally encourage increased mortgage refinancing activity. Increased refinancing activity reduces the expected life of the underlying mortgage loans, thereby reducing the cash flows expected to accrue to the MSRs. Reductions in the fair value of MSRs affect income primarily through change in fair value and change in impairment.

Following are the key inputs used in determining the fair value of MSRs recognized in mortgage loan sales at the time of initial recognition. The following values exclude MSR purchases:


	Quarter ended September 30,
	2018		2017
	Fair		Fair		Amortized
	value		value		cost
	(Amount recognized and unpaid principal balance of underlying mortgage loans in thousands)
MSR and pool characteristics:
Amount recognized	$	149,000	$	5,773	$	153,061
Unpaid principal balance of underlying mortgage loans	$	10,790,398	$	573,463	$	12,184,003
Weighted average servicing fee rate (in basis points)		37		31		32
Key inputs (1):
Pricing spread (2)
Range		7.3% – 13.6%		7.6% – 11.2%		7.6% – 14.6%
Weighted average		10.1%		10.7%		10.8%
Annual total prepayment speed (3)
Range		4.4% – 55.7%		3.9% – 46.8%		4.4% – 47.6%
Weighted average		11.8%		13.3%		9.5%
Life (in years)
Range		0.5 – 11.3		1.4 – 11.4		1.5 – 11.4
Weighted average		6.9		6.3		7.9
Per-loan annual cost of servicing
Range		$78 – $98		$78 – $98		$79 – $98
Weighted average		$92		$89		$89

(1)

Weighted average inputs are based on UPB of the underlying mortgage loans.

(2)

Pricing spread represents a margin that is applied to a reference interest rate’s forward rate curve to develop periodic discount rates. The Company applies a pricing spread to the United States Dollar London Interbank Offered Rate (“LIBOR”) curve for purposes of discounting cash flows relating to MSRs.

(3)

Prepayment speed is measured using Life Total CPR.


	Nine months ended September 30,
	2018	2017
	Fair	Fair	Amortized
	value	value	cost
	(Amount recognized and unpaid principal balance of underlying mortgage loans in thousands)
MSR and pool characteristics:
Amount recognized	$448,604	$19,702	$412,206
Unpaid principal balance of underlying mortgage loans	$32,095,458	$1,873,404	$33,890,209
Weighted average servicing fee rate (in basis points)	36	31	30
Key inputs (1):
Pricing spread (2)
Range	7.3% – 14.1%	7.6% – 11.2%	7.6% – 15.2%
Weighted average	10.2%	10.5%	10.7%
Annual total prepayment speed (3)
Range	3.9% – 61.8%	3.9% – 71.8%	3.4% – 47.6%
Weighted average	10.6%	12.5%	9.1%
Life (in years)
Range	0.5 – 11.6	0.8 – 11.5	1.5 – 12.2
Weighted average	7.5	6.6	8.1
Per-loan annual cost of servicing
Range	$78 – $98	$78 – $101	$79 – $101
Weighted average	$90	$89	$89

(1)

Weighted average inputs are based on UPB of the underlying mortgage loans.

(2)

Pricing spread represents a margin that is applied to a reference interest rate’s forward rate curve to develop periodic discount rates. The Company applies a pricing spread to the United States Dollar LIBOR curve for purposes of discounting cash flows relating to MSRs.

(3)

Prepayment speed is measured using Life Total CPR.

Following is a quantitative summary of key inputs used in the valuation and assessment for impairment of the Company’s MSRs as of the dates presented and the effect on fair value from adverse changes in those inputs (weighted averages are based upon UPB):


	September 30, 2018	December 31, 2017
	Fair	Fair	Amortized
	value	value	cost
	(Carrying value, unpaid principal balance of underlying
	mortgage loans and effect on fair value amounts in thousands)
MSR and pool characteristics:
Carrying value	$2,785,964	$638,010	$1,481,578
Unpaid principal balance of underlying mortgage loans	$193,659,378	$51,883,539	$114,365,698
Weighted average note interest rate	3.9%	4.0%	3.8%
Weighted average servicing fee rate (in basis points)	32	32	31
Key inputs (1):
Pricing spread (2):
Range	7.3% – 13.6%	7.6% – 14.1%	7.6% – 14.1%
Weighted average	10.0%	9.8%	10.3%
Effect on fair value of (3):
5% adverse change	($51,013)	($10,760)	($27,700)
10% adverse change	($100,182)	($21,155)	($54,376)
20% adverse change	($193,355)	($40,916)	($104,869)
Prepayment speed (4):
Range	6.9% – 41.6%	7.9% – 46.2%	7.4% – 44.1%
Weighted average	8.2%	10.5%	9.7%
Average life (in years):
Range	1.3 – 8.5	1.2 – 7.8	2.0 – 8.3
Weighted average	8.1	6.6	7.5
Effect on fair value of (3):
5% adverse change	($36,453)	($10,809)	($23,544)
10% adverse change	($71,779)	($21,239)	($46,284)
20% adverse change	($139,263)	($41,038)	($89,514)
Annual per-loan cost of servicing:
Range	$78 – $98	$78 – $97	$79 – $97
Weighted average	$93	$89	$89
Effect on fair value of (3):
5% adverse change	($22,201)	($6,247)	($11,216)
10% adverse change	($44,402)	($12,494)	($22,431)
20% adverse change	($88,803)	($24,987)	($44,863)

(1)

Weighted average inputs are based on UPB of the underlying mortgage loans.

(2)

The Company applies a pricing spread to the United States Dollar LIBOR curve for purposes of discounting cash flows relating to MSRs.

(3)

For MSRs carried at fair value, an adverse change in one of the above-mentioned key inputs is expected to result in a reduction in fair value which would be recognized in income. For MSRs carried at lower of amortized cost or fair value, an adverse change in one of the above-mentioned key inputs may have resulted in recognition of MSR impairment. The extent of the recognized MSR impairment depended on the relationship of fair value to the carrying value of such MSRs.

(4)

Prepayment speed is measured using Life Total CPR.

The preceding sensitivity analyses are limited in that they were performed as of a particular date; only contemplate the movements in the indicated inputs; do not incorporate changes to other inputs; are subject to the accuracy of the models and inputs used; and do not incorporate other factors that would affect the Company’s overall financial performance in such events, including operational adjustments made by management to account for changing circumstances. For these reasons, the preceding estimates should not be viewed as earnings forecasts.

Excess Servicing Spread Financing at Fair Value

The Company categorizes ESS as a “Level 3” fair value liability. Because the ESS is a claim to a portion of the cash flows from MSRs, the fair value measurement of the ESS is similar to that of MSRs. The Company uses the same discounted cash flow approach to measuring the ESS as it uses to measure MSRs except that certain inputs relating to the cost to service the mortgage loans underlying the MSR and certain ancillary income are not included as these cash flows do not accrue to the holder of the ESS. The key inputs used in the estimation of ESS fair value include pricing spread (discount rate) and prepayment speed. Significant changes to either of those inputs in isolation could result in a significant change in the fair value of ESS. Changes in these key inputs are not necessarily directly related.

ESS is generally subject to fair value increases when mortgage interest rates increase. Increasing mortgage interest rates normally slow mortgage refinancing activity. Decreased refinancing activity increases the life of the mortgage loans underlying the ESS, thereby increasing its fair value. Changes in the fair value of ESS are included in Net mortgage loan servicing fees—Change in fair value of excess servicing spread payable to PennyMac Mortgage Investment Trust.

Following are the key inputs used in estimating the fair value of ESS:


	September 30,	December 31,
	2018	2017
Carrying value (in thousands)	$223,275	$236,534
ESS and pool characteristics:
Unpaid principal balance of underlying mortgage loans (in thousands)	$24,058,366	$27,217,199
Average servicing fee rate (in basis points)	34	34
Average excess servicing spread (in basis points)	19	19
Key inputs (1):
Pricing spread (2):
Range	3.4% – 3.9%	3.8% – 4.3%
Weighted average	3.7%	4.1%
Annualized prepayment speed (3):
Range	7.6% – 38.4%	8.4% – 41.4%
Weighted average	9.0%	10.8%
Average life (in years):
Range	1.4 – 8.0	1.4 – 7.7
Weighted average	7.1	6.5

(1)

Weighted average inputs are based on UPB of the underlying mortgage loans.

(2)

The Company applies a pricing spread to the United States Dollar LIBOR curve for purposes of discounting cash flows relating to ESS.

(3)

Prepayment speed is measured using Life Total CPR.

Mortgage Servicing Liabilities

MSLs are categorized as “Level 3” fair value liabilities. The Company uses a discounted cash flow approach to estimate the fair value of MSLs. This approach consists of projecting net servicing cash flows discounted at a rate that management believes market participants would use in their determinations of fair value. The key inputs used in the estimation of the fair value of MSLs include the applicable pricing spread (discount rate), the prepayment rates of the underlying mortgage loans, and the per-loan annual cost to service the respective mortgage loans. Changes in the fair value of MSLs are included in Net servicing fees—Amortization, impairment and change in fair value of mortgage servicing rights and mortgage servicing liabilities in the consolidated statements of income.

Following are the key inputs used in determining the fair value of MSLs:


		September 30,		December 31,
		2018		2017
MSL and pool characteristics:
Carrying value (in thousands)	$	9,769	$	14,120
Unpaid principal balance of underlying mortgage loans (in thousands)	$	1,265,461	$	1,620,609
Servicing fee rate (in basis points)		25		25
Key inputs (1):
Pricing spread (2)		7.8%		7.7%
Prepayment speed (3)		31.6%		32.9%
Average life (in years)		3.9		3.5
Annual per-loan cost of servicing	$	372	$	404

(1)

Weighted average inputs are based on UPB of the underlying mortgage loans.

(2)

The Company applies a pricing spread to the United States Dollar LIBOR curve for purposes of discounting cash flows relating to MSLs.

(3)

Prepayment speed is measured using Life Total CPR.