8. Financial Instruments

Refer to Note 1 within the footnotes to the consolidated financial statements contained within Item 8 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 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, which are held primarily in connection with the business activities of the Company’s MBS & Rates division (which are being discontinued in the second quarter of 2013), are recorded within the Consolidated Statements of Financial Condition at fair value. ASC 820 “Fair Value Measurements and Disclosures” 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, at Fair Value — 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 generally 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 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, certain preferred stock, asset-backed and non-agency residential and commercial mortgage-backed securities and certain other debt obligations. In addition, Level 2 cash instruments also include mortgage loans originated by ClearPoint for which the fair value option (“FVO”) has been elected.

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 primarily based upon the prospective investor buy price.

Level 3 Cash Instruments

Level 3 cash instruments generally include non-agency commercial and residential mortgage backed securities positions, collateralized debt obligations, certain agency mortgage-backed securities 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 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 how other market participants value similar 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, exchange traded futures and options contracts. In addition, the prior-year period included ClearPoint forward sales and interest rate lock commitments (“IRLCs”).

TBAs: 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. The Company also economically hedged the mortgage lending activities of ClearPoint (the activities of which have been discontinued in connection with the Homeward Transaction), 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.

Exchange traded futures and options contracts: The Company utilized these financial instruments primarily for hedging strategies. These contracts are traded in active quoted markets and therefore are also generally classified as Level 1.

IRLCs: ClearPoint had entered into mortgage loan IRLCs in connection with its mortgage lending activities. These activities have been wound down in connection with the Homeward Transaction. At December 31, 2012, the fair value of the IRLCs were determined on an individual loan basis and are based on investor pricing tables stratified by product, note rate and term and considered the servicing release premium, expected loan origination fees and costs and loan pricing adjustments specific to each loan. The Company also applied 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 at December 31, 2012.

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. Historically, FATV held equity securities in public companies which were 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

At March 31, 2013, the Company’s sales and trading professionals in its MBS & Rates and Credit Products divisions (which will be discontinued in the second quarter of 2013) were responsible for pricing its 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 the Company’s financial instruments are properly valued.

Fair Value Hierarchy

The following table summarizes the categorization of the financial instruments within the fair value hierarchy at March 31, 2013:

	Assets at Fair Value
(In thousands of dollars)	Level 1		Level 2		Level 3		Total
Financial instruments owned
Agency mortgage-backed securities	$	—	$	462,940	$	5	$	462,945
Federal agency obligations	—		12,144		—		12,144
Corporate debt securities	—		1,156		—		1,156
Residential mortgage-backed securities	—		438		91		529
Equity securities	730		—		28		758
U.S. government obligations	25		—		—		25
Commercial mortgage-backed securities	—		—		18		18
Collateralized debt obligations	—		998		659		1,657
Total financial instruments owned, at fair value	755		477,676		801		479,232
Loans held for sale, ClearPoint, at fair value	—		7,693		—		7,693
Investments	—		—		21,597		21,597
Total	$	755	$	485,369	$	22,398	$	508,522

	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	$	20,034	$	—	$	—	$	20,034
Corporate debt securities	—		39		—		39
Derivatives (1)	1,640		—		—		1,640
Total securities sold, but not yet purchased	$	21,674	$	39	$	—	$	21,713

(1) Unrealized gains/(losses) relating to derivatives are reported in Financial instruments owned and Securities sold, but not yet purchased, at fair value in the Consolidated Statements of Financial Condition.

Included below is a discussion of the characteristics of certain of the Company’s Level 2 and Level 3 holdings at March 31, 2013. 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 values 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 $462.9 million, have a weighted average loan size of approximately $0.1 million paying interest of 4.4%, with a weighted average FICO score of 712. This portfolio has a weighted average coupon remitting payment of 3.5% and has a weighted average annualized constant prepayment rate of approximately 8.2%. 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 $12.1 million have a weighted average coupon of 2.2% and a weighted average maturity of 2022.

The Company’s Level 2 loans of approximately $7.7 million (unpaid principal of approximately $7.7 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%. There are no unrealized gains or losses arising from fair value changes of these loans as of March 31, 2013 and 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 $1.1 million have a weighted average credit rating of BB, have a weighted average issuance year of 2010 and a weighted average maturity of 2030.

Financial Instruments Classified as Level 3

Investments — Quantitative Disclosure About Significant Unobservable Inputs

The Company’s investments of approximately $21.6 million classified as Level 3, includes the Company’s investment in FATV of approximately $17.3 million, which is comprised of 19 holdings primarily in 7 privately held companies. Refer to Note 10 herein for additional information.

Valuation Technique	Unobservable Input	Range (Weighted Average)
Market comparable companies	Enterprise value/Revenue multiple	1.5x – 6.7x (5.9x)
	Discount applied to multiples	0.0% - 40.0% (27.0%)

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, 2012:

	Assets at Fair Value
(In thousands of dollars)	Level 1		Level 2		Level 3		Total
Financial instruments owned
Agency mortgage-backed securities	$	—	$	903,928	$	1,110	$	905,038
Loans	—		77,573		—		77,573
Federal agency obligations	—		46,021		—		46,021
Corporate debt securities	—		30,246		—		30,246
Residential mortgage-backed securities	—		23,077		149		23,226
Commercial mortgage-backed securities	—		4,880		18		4,898
Preferred stock	2,439		—		—		2,439
U.S. government obligations	1,996		100		—		2,096
Other debt obligations	—		2,074		—		2,074
Equity securities	675		—		28		703
Collateralized debt obligations	—		—		671		671
Derivatives	232		—		964		1,196
Total financial instruments owned, at fair value	5,342		1,087,899		2,940		1,096,181
Investments	—		—		20,478		20,478
Total	$	5,342	$	1,087,899	$	23,418	$	1,116,659

	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	$	128,504	$	—	$	—	$	128,504
Corporate debt securities	—		2,520		—		2,520
Equity securities	2		—		—		2
Derivatives	1,704		—		—		1,704
Total financial liabilities, at fair value	$	130,210	$	2,520	$	—	$	132,730

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 months ended March 31, 2013 and March 31, 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 March 31, 2013:

(In thousands of dollars)	Balance at December 31, 2012		Total gains or (losses) (realized and unrealized) (1)			Purchases		Sales			Settlements			Transfers in and/or out of Level 3		Balance at March 31, 2013		Changes in unrealized gains/(losses) on Level 3 assets still held at the reporting date (1)
Agency mortgage-backed securities	$	1,110	$	(45	)	$	—	$	(1,060	)	$	—		$	—	$	5	$	—
Collateralized debt obligations	671		(12		)	—		—			—			—		659		(12		)
Residential mortgage-backed securities	149		4			—		(50		)	(12		)	—		91		—
Equities	28		—			—		—			—			—		28		—
Commercial mortgage-backed securities	18		—			—		—			—			—		18		—
Investments	20,478		172			947		—			—			—		21,597		188
Derivatives	964		—			—		—			(964		)	—		—		—
Total	$	23,418	$	119		$	947	$	(1,110	)	$	(976	)	$	—	$	22,398	$	176

(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 March 31, 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 March 31, 2012		Changes in unrealized gains/(losses) on Level 3 assets still held at the reporting date (1)
Commercial mortgage-backed securities	$	38,154	$	(3,505	)	$	14,845	$	(20,163	)	$	(134	)	$	(1,347	)	$	27,850	$	(3,019	)
Residential mortgage-backed securities	18,419		(548		)	26,529		(16,156		)	(682		)	(959		)	26,603		(32		)
Other debt obligations	192		3			3,254		(3,131		)	—			—			318		(2		)
Agency mortgage-backed securities	1,367		(68		)	295		(1,232		)	—			—			362		(60		)
Collateralized debt obligations	647		(62		)	—		—			—			—			585		(61		)
Equities	112		(9		)	—		—			—			—			103		(10		)
Preferred stock	571		106			682		(1,359		)	—			—			—		—
Investments	18,310		132			—		—			(2		)	—			18,440		325
Derivatives	1,696		885			—		—			(1,696		)	—			885		885
Total	$	79,468	$	(3,066	)	$	45,605	$	(42,041	)	$	(2,514	)	$	(2,306	)	$	75,146	$	(1,974	)

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

(2) During the three months ended March 31, 2012, the Company transferred approximately $1.3 million of commercial mortgage backed securities and approximately $1.0 million of residential mortgage-backed securities from Level 3 to Level 2 due to price discovery resulting from Company trading activity occurring in close proximity to March 31, 2012.