FAIR VALUE OF FINANCIAL INSTRUMENTS

ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC Topic 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity’s own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:


•	Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date.


•	Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.


•	Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, and management may conclude that its financial instruments should be reclassified to a different level in the future if a change in type of inputs occurs.

The following table presents the Company’s financial instruments that are measured at fair value on a recurring basis by their valuation hierarchy levels as of the dates indicated:



	September 30, 2018
	Fair Value		Level 1 - Unadjusted Quoted Prices in Active Markets		Level 2 - Observable Inputs		Level 3 - Unobservable Inputs
Assets carried at fair value:
Investments in securities:
Mortgage-backed securities	$	3,294,510	$	—	$	3,288,274	$	6,236
U.S. Treasuries	—		—		—		—
Derivative assets:
Interest rate swaps	694		—		694		—
Eurodollar futures	—		—		—		—
TBA securities	871		—		871		—
Options on U.S. Treasury futures	1,047		1,047		—		—
Total assets carried at fair value	$	3,297,122	$	1,047	$	3,289,839	$	6,236

Liabilities carried at fair value:
TBA securities	2,039		—		2,039		—
Total liabilities carried at fair value	$	2,039	$	—	$	2,039	$	—

	December 31, 2017
	Fair Value		Level 1 - Unadjusted Quoted Prices in Active Markets		Level 2 - Observable Inputs		Level 3 - Unobservable Inputs
Assets carried at fair value:
Investments in securities:
Mortgage-backed securities	$	3,026,989	$	—	$	3,019,746	$	7,243
U.S. Treasuries	146,530		146,530		—		—
Derivative assets:
Interest rate swaps	791		—		791		—
Eurodollar futures	666		666		—		—
TBA securities	1,483		—		1,483		—
Total assets carried at fair value	$	3,176,459	$	147,196	$	3,022,020	$	7,243

Liabilities carried at fair value:
TBA securities	269		—		269		—
Total liabilities carried at fair value	$	269	$	—	$	269	$	—

The fair value of interest rate swaps is measured using the income approach with the primary input being the forward interest rate swap curve, which is considered an observable input, and thus their fair values are considered Level 2 measurements. Eurodollar futures and options on U.S. Treasury futures are valued based on closing exchange prices on these contracts and are classified accordingly as Level 1 measurements. The fair value of TBA securities is estimated using methods similar those used to fair value the Company’s Level 2 MBS.

The fair value measurements for a majority of the Company's MBS are considered Level 2 because these securities are substantially similar to securities that either are actively traded or have been recently traded in their respective markets. The Company determines the fair value of its Level 2 securities based on prices received from the Company's primary pricing service as well as other pricing services and brokers. The Company evaluates the third party prices it receives to assess their reasonableness. Although the Company does not adjust third party prices, they may be excluded from use in the determination of a security's fair value if they are significantly different from other observable market data. In valuing a security, the primary pricing service uses either a market approach, which uses observable prices and other relevant information that is generated by market transactions of identical or similar securities, or an income approach, which uses valuation techniques to convert future amounts to a single, discounted present value amount. The Company also reviews the assumptions and inputs utilized in the valuation techniques of its primary pricing service. Examples of these observable inputs and assumptions include market interest rates, credit spreads, and projected prepayment speeds, among other things.

The Company owns certain non-Agency MBS for which there are not sufficiently recent trades of substantially similar securities, and their fair value measurements are thus considered Level 3. The Company determines the fair value of its Level 3 securities by discounting the estimated future cash flows derived from cash flow models using significant inputs which are determined by the Company when market observable inputs are not available. Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information. Significant changes in any of these inputs in isolation may result in a significantly different fair value measurement. Level 3 assets are generally most sensitive to the default rate and severity assumptions.

The activity of the Company’s non-Agency MBS measured at fair value on a recurring basis using Level 3 inputs is presented in the following table for the periods indicated:



	Nine Months Ended
	September 30, 2018
Balance as of beginning of period	$	7,243
Unrealized loss included in OCI	(862		)
Principal payments	(1,031		)
Accretion	886
Balance as of end of period	$	6,236

The following table presents a summary of the carrying value and estimated fair values of the Company’s financial instruments as of the dates indicated:



	September 30, 2018				December 31, 2017
	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets:
Mortgage-backed securities	$	3,294,510	$	3,294,510	$	3,026,989	$	3,026,989
U.S. Treasuries	—		—		146,530		146,530
Mortgage loans held for investment, net ⁽¹⁾	12,342		9,165		15,738		12,973
Derivative assets	2,612		2,612		2,940		2,940
Liabilities:
Repurchase agreements ⁽²⁾	$	2,690,858	$	2,690,858	$	2,565,902	$	2,565,902
Non-recourse collateralized financing ⁽¹⁾	3,709		3,742		5,520		5,554
Derivative liabilities	2,039		2,039		269		269


(1)	The Company determines the fair value of its mortgage loans held for investment, net and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate the fair value of the Company’s Level 3 non-Agency MBS.


(2)	The carrying value of repurchase agreements generally approximates fair value due to their short-term maturities.