Financial Instruments

9 Months Ended

Sep. 30, 2012

Financial Instruments

Financial Instruments

8.Financial Instruments

Refer to Note 1 within the footnotes to the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, for a detailed discussion of accounting policies related to the Company’s financial instruments & investments, loans and derivative financial instruments.

The Company’s financial instruments are recorded within the Consolidated Statements of Financial Condition at fair value.  ASC 820 “Fair Value Measurements and Disclosures” (“ASC 820”) defines fair value as the price that would be received upon the sale of an asset or paid upon the transfer of a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date and establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the reliability of inputs as follows:

Level 1: Quoted prices in active markets that the Company has the ability to access at the reporting date, for identical assets or liabilities.

Level 2: Directly or indirectly observable prices in active markets for similar assets or liabilities; quoted prices for identical or similar items in markets that are not active; inputs other than quoted prices (e.g., interest rates, yield curves, credit risks, volatilities); or “market corroborated inputs.”

Level 3: Unobservable inputs that reflect management’s own assumptions about the assumptions market participants would make.

** Prices are not adjusted for the effects, if any, of the Company holding a large block relative to the overall trading volume (referred to as a “blockage factor”).

The availability of observable inputs can vary from product to product and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.

ASC 820 also provides (i) general guidance on determining fair value when markets are inactive including the use of judgment in determining whether a transaction in a dislocated market represents fair value, the inclusion of market participant risk adjustments when an entity significantly adjusts observable market data based on unobservable inputs, and the degree of reliance to be placed on broker quotes or pricing services as well as (ii) additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly declined and guidance on identifying circumstances that indicate a transaction is not orderly.

Fair Valuation Methodology

Cash Equivalents — These financial assets represent cash in banks or cash invested in highly liquid investments with original maturities less than 90 days that are not segregated for regulatory purposes or held for sale in the ordinary course of business.  These investments are valued at par, which represent fair value, and are considered Level 1.  Refer to Note 3 herein for additional information.

Financial Instruments Owned/Securities Sold But Not Yet Purchased — These financial instruments primarily consist of investments in fixed income securities, as well as holdings in equity securities.  The Company has no direct exposure to European sovereign debt.

Level 1 Cash Instruments

Level 1 cash instruments include U.S. government obligations and actively traded listed preferred stock and equity securities (if not subject to legal restriction on transfer).  These instruments are generally traded in active, quoted and highly liquid markets.

Level 2 Cash Instruments

Level 2 cash instruments generally include agency mortgage-backed securities, federal agency obligations, corporate debt, mortgage loans originated by ClearPoint for which the fair value option (“FVO”) has been elected and certain preferred stock, asset-backed and non-agency residential and commercial mortgage-backed securities and certain other debt obligations.

In determining fair value for Level 2 financial instruments, management considers recent purchases or sales of the financial assets, benchmark securities and yields, discounted cash flow techniques, recently executed market transactions of comparable size, issuer spreads and bids/offers.  Fair value for ClearPoint’s loans is determined utilizing observable market factors and is principally based upon the fair value of the “to-be-announced” (“TBA”) forward securities market (refer to “Derivatives” below).

Level 3 Cash Instruments

Level 3 cash instruments primarily include non-agency commercial and residential mortgage backed securities positions and certain other debt obligations.  In determining fair value for Level 3 financial instruments, management maximizes the use of market observable information when available.  Management considers factors such as recent purchases or sales of the financial assets, discounted cash flow techniques, bids that were received, and various benchmarking techniques, including spread comparisons to other similar financial assets recently traded, or spreads to observable factors such as yield curves.  Management considers its valuation methodologies consistent with assumptions in how other market participants value certain financial assets.

Level 3 cash instruments also includes the Company’s investment in FA Technology Ventures, L.P. (“FATV” or “the Partnership”), further described below.

Derivatives — These financial instruments primarily consist of TBAs, forward sales and interest rate lock commitments (“IRLCs”).

TBAs and forward sales:  The Company utilizes derivatives for trading strategies and economic hedging strategies.  The Company economically hedges certain of its mortgage-backed and U.S. government securities trading, and the mortgage lending activities of ClearPoint, through the use of TBAs and forward sale agreements.  A TBA is a forward mortgage-backed security whose collateral remains “to-be-announced” until just prior to the trade settlement.  Forward sale agreements are entered into by ClearPoint and are valued based upon the TBA.  TBAs are traded in an active quoted market and therefore generally classified as Level 1.

IRLCs:  The Company enters into mortgage loan IRLCs in connection with its mortgage lending activities.  The fair value of the IRLCs are determined on an individual loan basis and are based on investor pricing tables stratified by product, note rate and term and considers the servicing release premium, expected loan origination fees and costs and loan pricing adjustments specific to each loan.  The Company also applies an estimated rate of closure based on historical experience in determining the notional amount of the loans expected to be funded.  All of these factors combined results in the classification of the IRLCs as Level 3.

Investments — These financial assets primarily represent the Company’s investment in FATV, a venture capital limited partnership which provides early stage growth capital to companies in the information and new energy technology sectors.  Valuation techniques applied by FATV GP LLC (the “General Partner”) to the underlying portfolio companies predominantly include consideration of comparable market transactions and the use of valuation models to determine the discounted value of estimated future cash flows, adjusted as appropriate for market and/or other risk factors.  In addition, from time to time, FATV holds equity securities in public companies which are valued based upon quoted market prices.  This investment is classified as Level 3 as the majority of the valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

Valuation Processes and Controls

Our sales and trading professionals in our revenue producing units are responsible for pricing our financial instruments.  The Company employs an independent control process in order to validate these prices.  This control process, which involves both the Company’s risk management and finance personnel, is designed to ensure 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 that the assumptions are reasonable.

Fair value is generally determined through a variety of factors, such as recent purchases or sales of the financial assets, bids that were received, and various benchmarking techniques, including spread comparisons to other similar assets recently traded or spreads to other observable factors such as yield curves.  The Company’s independent control process includes leveraging pricing information obtained from external data providers to assess the reasonableness of its marks, generally for the Company’s most highly liquid financial instruments, as this data tends to be generally reliable for positions that are actively traded.  For the Company’s less liquid financial instruments, the Company’s independent control process includes comparing month-end marks to recent trading activity, benchmarking price changes to observable market indices, reviewing benchmarking techniques and analyzing external pricing data for trends.  These independent procedures are critical to ensuring our financial instruments are properly valued.

Fair Value Hierarchy

The following tables summarize the categorization of the financial instruments within the fair value hierarchy including those for which the Company accounts for under the FVO, at September 30, 2012:

	Assets at Fair Value
(In thousands of dollars)	Level 1		Level 2		Level 3		Total
Financial instruments owned
Agency mortgage-backed securities	$	—	$	863,143	$	8	$	863,151
Loans	—		80,961		—		80,961
Federal agency obligations	—		69,973		—		69,973
Corporate debt securities	—		22,725		—		22,725
Residential mortgage-backed securities	—		11,053		11,281		22,334
U.S. government obligations	21,758		99		—		21,857
Other debt obligations	—		377		10,487		10,864
Commercial mortgage-backed securities	—		97		3,819		3,916
Equity securities	664		—		98		762
Collateralized debt obligations	—		—		551		551
Derivatives	684		—		2,953		3,637
Investments	—		—		19,253		19,253
Total financial assets at fair value	$	23,106	$	1,048,428	$	48,450	$	1,119,984

	Liabilities at Fair Value
(In thousands of dollars)	Level 1		Level 2		Level 3		Total
Securities sold but not yet purchased
U.S. Government obligations	$	249,516	$	—	$	—	$	249,516
Corporate debt securities	—		5,673		—		5,673
Preferred stock	1,864		—		—		1,864
Derivatives	5,221		—		—		5,221
Total financial liabilities at fair value	$	256,601	$	5,673	$	—	$	262,274

Included below is a discussion of the characteristics of the Company’s Level 2 and Level 3 holdings at September 30, 2012.  Unless otherwise stated, fair value of Level 2 assets are determined based upon observable third party information including recent trading activity, broker quotes and other relevant market data as noted above.  Fair value for Level 3 assets are based predominantly on management’s own assumptions about the assumptions market participants would make.

Financial Instruments Classified as Level 2

The Company’s agency mortgage-backed securities positions classified as Level 2, of approximately $863.1 million, have a weighted average loan size of approximately $0.2 million paying interest of 4.7%, with a weighted average FICO score of 743.  This portfolio has a weighted average coupon remitting payment of 4.0% and has a weighted average annualized constant prepayment rate of approximately 22.9%.  Fair value is determined through a combination of matrix pricing as well as the information noted in the preceding paragraph.

The Company’s Level 2 federal agency obligations of approximately $70.0 million have a weighted average coupon of 1.8% and a weighted average maturity of 2019.

The Company’s Level 2 loans of approximately $81.0 million (unpaid principal of approximately $77.6 million), which are related to the mortgage lending activities of ClearPoint and for which the FVO has been elected, have a weighted average loan size of approximately $0.2 million and has a weighted average coupon remitting payment of 3.7%.  Unrealized losses arising from fair value changes of approximately $0.4 million have been recorded within Principal transactions within the Consolidated Statements of Operations as of September 30, 2012.  There are no loans 90 days or more past due and no loans are in non-accrual status.  The loans are underwritten using standards prescribed by conventional mortgage lenders and loan buyers such as the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation.

The Company’s net holdings of corporate debt securities classified as Level 2 of approximately $17.1 million have a weighted average credit rating of BBB, have a weighted average issuance year of 2007 and a weighted average maturity of 2027.

The Company’s Level 2 non-agency residential mortgage backed securities of approximately $11.1 million are primarily senior tranches, have a weighted average credit rating of DDD and a weighted average issuance year of 2005.

Financial Instruments Classified as Level 3

Non-Agency Residential Mortgage Backed Securities – Disclosure About Significant Unobservable Inputs

(Dollars in thousands)

Valuation Technique	Fair Value at September 30, 2012		Unobservable Input	Range (Weighted Average)
Discounted cash flow	$	11,281	Default rate(1)	6.0%-18.0% (9.8%)
			Prepayment rate(2)	0.5%-15% (6.3%)
			Loss severity(1)	50%-65% (55.5%)
			Discount rate(1)	5.4%-8.6% (6.8%)

(1)Increases in this assumption would result in a lower fair value, whereas decreases in this assumption would result in a higher fair value.

(2)Increases in this assumption would result in a higher fair value, whereas decreases in this assumption would result in a lower fair value.

Commercial Mortgage Backed Securities – Disclosure About Significant Unobservable Inputs

Valuation Technique

(Dollars in thousands)	Fair Value at September 30, 2012		Unobservable Input	Range (Weighted Average)
Comparable market data	$	3,819	Spread over benchmark(1)	+3.0 to +13.0 (+9.0%)

(1)Increases in this assumption would result in a higher fair value, whereas decreases in this assumption would result in a lower fair value.

Other Debt Obligations – Disclosure About Significant Unobservable Inputs

Valuation Technique

(Dollars in thousands)	Fair Value at September 30, 2012		Unobservable Input	Range (Weighted Average)
Discounted cash flow	$	10,487	Default rate(1)	0.0%-0.5% (0.4%)
			Prepayment rate(2)	1.2%-15.0% (2.9%)
			Loss severity(1)	0.0%-25.0% (22.2%)
			Discount rate(1)	0.6%-1.9% (0.6%)

(1)Increases in this assumption would result in a lower fair value, whereas decreases in this assumption would result in a higher fair value.

(2)Increases in this assumption would result in a higher fair value, whereas decreases in this assumption would result in a lower fair value.

Interest Rate Lock Commitments – Disclosure About Significant Unobservable Inputs

IRLCs are reported as derivatives and are classified Level 3.  The significant unobservable input is ClearPoint’s estimated rate of closure of 71.0%, representing the percentage of ClearPoint’s loan commitments expected to fund, which is based on historical experience.  A reduction in this unobservable input would result in a lower fair value for these financial instruments.

Refer to Note 9 herein for additional information.

Investments – Quantitative Disclosure About Significant Unobservable Inputs

The Company’s investments of approximately $19.3 million classified as Level 3, includes the Company’s investment in FATV of approximately $16.0 million.  Refer to Note 10 herein for additional information.

Valuation Technique	Unobservable Input	Range (Weighted Average)
Market comparable companies	Enterprise value/Revenue multiple	1.5x – 7.2x (5.9x)
	Discount applied to multiples	0.0% - 45.0% (23.0%)

An increase in the enterprise value/revenue multiple would result in a higher fair value for these investments, whereas, an increase in the discounts applied to these multiples would reduce fair value.

Nonrecurring Fair Value Measurements – Quantitative Disclosure About Significant Unobservable Inputs

The Company’s assets measured at fair value on a nonrecurring basis solely relate to Goodwill arising from various business combinations which would be classified as Level 3 within the fair value hierarchy.  Refer to Note 12 herein for additional information.

The following table summarizes the categorization of the financial instruments within the fair value hierarchy including those for which the Company accounts for under the FVO at December 31, 2011:

	Assets at Fair Value
(In thousands of dollars)	Level 1		Level 2		Level 3		Total
Financial instruments owned
Agency mortgage-backed securities	$	—	$	1,084,254	$	1,367	$	1,085,621
Loans	—		228,226		—		228,226
Federal agency obligations	—		158,774		—		158,774
Commercial mortgage-backed securities	—		—		38,154		38,154
Residential mortgage-backed securities	—		—		18,419		18,419
Corporate debt securities	—		14,524		—		14,524
U.S. Government obligations	5,789		—		—		5,789
Preferred stock	316		—		1,301		1,617
Equity securities	889		—		112		1,001
Collateralized debt obligations	—		—		647		647
Other debt obligations	—		—		192		192
Derivatives	—		—		1,696		1,696
Investments	—		—		18,310		18,310
Total financial assets at fair value	$	6,994	$	1,485,778	$	80,198	$	1,572,970

	Liabilities at Fair Value
(In thousands of dollars)	Level 1		Level 2		Level 3		Total
Securities sold but not yet purchased
U.S. Government obligations	$	158,059	$	—	$	—	$	158,059
Corporate debt securities	—		12,254		—		12,254
Federal agency obligations	—		11,796		—		11,796
Preferred stock	184		—		730		914
Equity securities	2		—		—		2
Derivatives	1,971		—		—		1,971
Total financial liabilities at fair value	$	160,216	$	24,050	$	730	$	184,996

The Company reviews its financial instrument classification on a quarterly basis.  As the observability and strength of valuation attributes change, reclassifications of certain financial assets or liabilities may occur between levels.  The Company’s policy is to utilize an end-of-period convention for determining transfers in or out of Levels 1, 2 and 3.  During the three and nine months ended September 30, 2012, there were no transfers between Levels 1 and 2.

The following table summarizes the changes in the Company’s Level 3 financial instruments for the three months ended September 30, 2012:

(In thousands of dollars)	Balance at June 30, 2012		Total gains or (losses) (realized and unrealized) (1)			Purchases		Sales			Settlements			Transfers in and/or out of Level 3		Balance at September 30, 2012		Changes in unrealized gains/(losses) on Level 3 assets still held at the reporting date (1)
Commercial mortgage-backed securities	$	5,682	$	(424	)	$	133	$	(1,568	)	$	(4	)	$	—	$	3,819	$	(380	)
Residential mortgage-backed securities	10,355		331			12,700		(11,482		)	(623		)	—		11,281		37
Other debt obligations	2,553		20			11,362		(3,420		)	(28		)	—		10,487		3
Agency mortgage-backed securities	1,486		(80		)	3		(1,401		)	—			—		8		35
Collateralized debt obligations	554		(3		)	—		—			—			—		551		234
Equities	112		(14		)	—		—			—			—		98		(14		)
Investments	19,090		163			—		—			—			—		19,253		32
Derivatives	1,737		2,953			—		—			(1,737		)	—		2,953		2,953
Total	$	41,569	$	2,946		$	24,198	$	(17,871	)	$	(2,392	)	$	—	$	48,450	$	2,900

(1)Realized and unrealized gains/(losses) are reported in Principal transactions in the Consolidated Statements of Operations.

The following table summarizes the changes in the Company’s Level 3 financial instruments for the three months ended September 30, 2011:

(In thousands of dollars)	Balance at June 30, 2011		Total gains or (losses) (realized and unrealized) (1)			Purchases		Sales			Settlements			Transfers in and/or out of Level 3 (2)		Balance at September 30, 2011		Changes in unrealized gains/(losses) on Level 3 assets still held at the reporting date (1)
Commercial mortgage-backed securities	$	56,359	$	(6,258	)	$	—	$	(22,353	)	$	(32	)	$	—	$	27,716	$	(4,355	)
Residential mortgage-backed securities	27,193		75			28,568		(21,289		)	(1,652		)	—		32,895		(379		)
Other debt obligations	15,998		(94		)	27,464		(23,299		)	(1,160		)	—		18,909		(3		)
Agency mortgage-backed securities	8,013		(95		)	2,839		(9,709		)	—			—		1,048		(124		)
Collateralized debt obligations	1,424		99			—		(877		)	—			—		646		136
Equities	60		165			—		—			—			—		225		(55		)
Investments	16,098		2,857			1,264		—			(1,196		)	—		19,023		2,872
Derivatives	574		3,349			—		—			(574		)	—		3,349		3,349
Total	$	125,719	$	98		$	60,135	$	(77,527	)	$	(4,614	)	$	—	$	103,811	$	1,441

(1)Realized and unrealized gains/(losses) are reported in Principal transactions in the Consolidated Statements of Operations.

(2)During the three months ended September 30, 2011, there were no transfers in or out of Level 3.

The following table summarizes the changes in the Company’s Level 3 financial instruments for the nine months ended September 30, 2012:

(In thousands of dollars)	Balance at December 31, 2011		Total gains or (losses) (realized and unrealized) (1)			Purchases		Sales			Settlements			Transfers in and/or out of Level 3(2)			Balance at September 30, 2012		Changes in unrealized gains/(losses) on Level 3 assets still held at the reporting date (1)
Commercial mortgage-backed securities	$	38,154	$	(6,497	)	$	7,383	$	(33,058	)	$	(62	)	$	(2,101	)	$	3,819	$	(1,322	)
Residential mortgage-backed securities	18,419		(555		)	11,680		(17,329		)	(934		)	—			11,281		12
Other debt obligations	192		10			16,153		(5,848		)	(20		)	—			10,487		(1		)
Agency mortgage-backed securities	1,367		(140		)	15		(1,232		)	(2		)	—			8		4
Collateralized debt obligations	647		(96		)	60		(60		)	—			—			551		(93		)
Equities	112		(14		)	—		—			—			—			98		(14		)
Preferred stock	571		188			5,624		(6,383		)	—			—			—		—
Investments	18,310		156			800		—			(13		)	—			19,253		210
Derivatives	1,696		5,575			—		—			(4,318		)	—			2,953		2,953
Total	$	79,468	$	(1,373	)	$	41,715	$	(63,910	)	$	(5,349	)	$	(2,101	)	$	48,450	$	1,749

(1)Realized and unrealized gains/(losses) are reported in Principal transactions in the Consolidated Statements of Operations.

(2)During the nine months ended September 30, 2012, the Company transferred approximately $2.1 million of commercial mortgage backed securities from Level 3 to Level 2 due to price discovery resulting from Company trading activity occurring in close proximity to the respective quarter-end.

The following table summarizes the changes in the Company’s Level 3 financial instruments for the nine months ended September 30, 2011:

(In thousands of dollars)	Balance at December 31, 2010		Total gains or (losses) (realized and unrealized) (1)			Purchases		Sales			Settlements			Transfers in and/or out of Level 3(2)			Balance at September 30, 2011		Changes in unrealized gains/(losses) on Level 3 assets still held at the reporting date (1)
Commercial mortgage-backed securities	$	46,571	$	8,828		$	67,742	$	(91,668	)	$	(107	)	$	(3,650	)	$	27,716	$	(6,889	)
Residential mortgage-backed securities	33,604		(79		)	32,923		(30,564		)	(2,989		)	—			32,895		(379		)
Other debt obligations	5,843		(14		)	32,005		(18,765		)	(160		)	—			18,909		54
Agency mortgage-backed securities	806		(147		)	1,111		(722		)	—			—			1,048		(187		)
Collateralized debt obligations	23,235		11,570			9,056		(39,122		)	(525		)	(3,568		)	646		61
Equities	60		165			—		—			—			—			225		(55		)
Investments	18,084		2,539			1,367		—			(2,967		)	—			19,023		2,446
Derivatives	—		4,608			—		—			(1,259		)	—			3,349		3,349
Total	$	128,203	$	27,470		$	144,204	$	(180,841	)	$	(8,007	)	$	(7,218	)	$	103,811	$	(1,600	)

(1)Realized and unrealized gains/(losses) are reported in Principal transactions in the Consolidated Statements of Operations.

(2)During the nine months ended September 30, 2011, the Company transferred approximately $3.7 million of commercial mortgage backed securities and approximately $3.6 million of collateralized debt obligations from Level 3 to Level 2 due to price discovery resulting from Company trading activity occurring in close proximity to the respective quarter-end.