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Financial Instruments and Fair Value Disclosures

3 Months Ended

Feb. 28, 2018

Financial Instruments and Fair Value Disclosures

The following table presents the carrying amounts and estimated fair values of financial instruments held by the Company at February 28, 2018 and November 30, 2017, using available market information and what the Company believes to be appropriate valuation methodologies. Considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions and/or estimation methodologies might have a material effect on the estimated fair value amounts. The table excludes cash and cash equivalents, restricted cash, receivables, net and accounts payable, all of which had fair values approximating their carrying amounts due to the short maturities and liquidity of these instruments.



		February 28, 2018			November 30, 2017
(In thousands)	Fair Value Hierarchy	Carrying Amount		Fair Value	Carrying Amount	Fair Value
ASSETS
Rialto:
Loans receivable, net	Level 3	$	1,932	1,932	1,933	1,933
Investments held-to-maturity	Level 3	$	210,882	229,551	179,659	199,190
Lennar Financial Services:
Loans held-for-investment, net	Level 3	$	69,832	63,171	44,193	41,795
Investments held-to-maturity	Level 2	$	60,831	60,441	52,327	52,189
LIABILITIES
Lennar Homebuilding senior notes and other debts payable	Level 2	$	10,382,540	10,476,731	6,410,003	6,598,848
Rialto notes payable and other debts payable	Level 2	$	438,879	448,114	625,081	644,644
Lennar financial Services notes and other debts payable	Level 2	$	772,240	772,240	937,431	937,431

The following methods and assumptions are used by the Company in estimating fair values:

Rialto—The fair values for loans receivable, net are based on the fair value of the collateral less estimated cost to sell or discounted cash flows, if estimable. The fair value for investments held-to-maturity is based on discounted cash flows. For notes and other debts payable, the fair value is calculated based on discounted cash flows using quoted interest rates and for the warehouse repurchase financing agreements fair values approximate their carrying value due to their short-term maturities.

Lennar Financial Services—The fair values above are based on quoted market prices, if available. The fair values for instruments that do not have quoted market prices are estimated by the Company on the basis of discounted cash flows or other financial information. For notes and other debts payable, the fair values approximate their carrying value due to variable interest pricing terms and the short-term nature of the borrowings.

Lennar Homebuilding—For senior notes and other debts payable, the fair value of fixed-rate borrowings is primarily based on quoted market prices and the fair value of variable-rate borrowings is based on expected future cash flows calculated using current market forward rates.

Fair Value Measurements:

GAAP provides a framework for measuring fair value, expands disclosures about fair value measurements and establishes a fair value hierarchy which prioritizes the inputs used in measuring fair value summarized as follows:

Level 1: Fair value determined based on quoted prices in active markets for identical assets.

Level 2: Fair value determined using significant other observable inputs.

Level 3: Fair value determined using significant unobservable inputs.

The Company’s financial instruments measured at fair value on a recurring basis are summarized below:



(In thousands)	Fair Value Hierarchy	Fair Value at February 28, 2018		Fair Value at November 30, 2017
Rialto Financial Assets:
RMF loans held-for-sale (1)	Level 3	$	123,398	234,403
Credit default swaps (2)	Level 2	$	1,084	995
Lennar Financial Services Assets (Liabilities):
Loans held-for-sale (3)	Level 2	$	689,172	937,516
Investments available-for-sale	Level 1	$	57,768	57,439
Mortgage loan commitments	Level 2	$	11,654	9,873
Forward contracts	Level 2	$	4,844	1,681
Mortgage servicing rights	Level 3	$	36,772	31,163


(1)	The aggregate fair value of Rialto loans held-for-sale of $123.4 million at February 28, 2018 is below their aggregate principal balance of $125.5 million by $2.1 million. The aggregate fair value of loans held-for-sale of $234.4 million at November 30, 2017 was below their aggregate principal balance of $235.4 million by $1.0 million.


(2)	Rialto's credit default swaps are included within Rialto's other assets.


(3)	The aggregate fair value of Lennar Financial Services loans held-for-sale of $689.2 million at February 28, 2018 exceeds their aggregate principal balance of $676.8 million by $12.4 million. The aggregate fair value of Lennar Financial Services loans held-for-sale of $937.5 million at November 30, 2017 exceeded their aggregate principal balance of $908.8 million by $28.7 million.

The estimated fair values of the Company’s financial instruments have been determined by using available market information and what the Company believes to be appropriate valuation methodologies. Considerable judgment is required in interpreting market data to develop the estimates of fair value. The use of different market assumptions and/or estimation methodologies might have a material effect on the estimated fair value amounts. The following methods and assumptions are used by the Company in estimating fair values:

Rialto loans held-for-sale- The fair value of loans held-for-sale is calculated from model-based techniques that use discounted cash flow assumptions and the Company’s own estimates of CMBS spreads, market interest rate movements and the underlying loan credit quality. Loan values are calculated by allocating the change in value of an assumed CMBS capital structure to each loan. The value of an assumed CMBS capital structure is calculated, generally, by discounting the cash flows associated with each CMBS class at market interest rates and at the Company’s own estimate of CMBS spreads. The Company estimates CMBS spreads by observing the pricing of recent CMBS offerings, secondary CMBS markets, changes in the CMBX index, and general capital and commercial real estate market conditions. Considerations in estimating CMBS spreads include comparing the Company’s current loan portfolio with comparable CMBS offerings containing loans with similar duration, credit quality and collateral composition. These methods use unobservable inputs in estimating a discount rate that is used to assign a value to each loan. While the cash payments on the loans are contractual, the discount rate used and assumptions regarding the relative size of each class in the CMBS capital structure can significantly impact the valuation. Therefore, the estimates used could differ materially from the fair value determined when the loans are sold to a securitization trust.

Rialto credit default swaps- The fair value of credit default swaps (derivatives) is based on quoted market prices for similar investments traded in active markets.

Lennar Financial Services loans held-for-sale- Fair value is based on independent quoted market prices, where available, or the prices for other mortgage whole loans with similar characteristics. Management believes carrying loans held-for-sale at fair value improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. In addition, the Company recognizes the fair value of its rights to service a mortgage loan as revenue upon entering into an interest rate lock loan commitment with a borrower. The fair value of these servicing rights is included in Lennar Financial Services’ loans held-for-sale as of February 28, 2018 and November 30, 2017. Fair value of servicing rights is determined based on actual sales of servicing rights on loans with similar characteristics.

Lennar Financial Services investments available-for-sale- The fair value of these investments is based on the quoted market prices for similar financial instruments.

Lennar Financial Services mortgage loan commitments- Fair value of commitments to originate loans is based upon the difference between the current value of similar loans and the price at which the Lennar Financial Services segment has committed to originate the loans. The fair value of commitments to sell loan contracts is the estimated amount that the Lennar Financial Services segment would receive or pay to terminate the commitments at the reporting date based on market prices for similar financial instruments. In addition, the Company recognizes the fair value of its rights to service a mortgage loan as revenue upon entering into an interest rate lock loan commitment with a borrower. The fair value of servicing rights is

determined based on actual sales of servicing rights on loans with similar characteristics. The fair value of the mortgage loan commitments and related servicing rights is included in Lennar Financial Services’ other assets.

Lennar Financial Services forward contracts- Fair value is based on quoted market prices for similar financial instruments. The fair value of forward contracts is included in the Lennar Financial Services segment's other assets as of February 28, 2018 and November 30, 2017, respectively.

The Lennar Financial Services segment uses mandatory mortgage-backed securities ("MBS") forward commitments, option contracts and investor commitments to hedge its mortgage-related interest rate exposure. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments, option contracts and loan sales transactions is managed by limiting the Company’s counterparties to investment banks, federally regulated bank affiliates and other investors meeting the Company’s credit standards. The segment’s risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments and option contracts. At February 28, 2018, the segment had open commitments amounting to $1.3 billion to sell MBS with varying settlement dates through May 2018.

Lennar Financial Services mortgage servicing rights- Lennar Financial Services records mortgage servicing rights when it sells loans on a servicing-retained basis or through the acquisition or assumption of the right to service a financial asset. The fair value of the mortgage servicing rights is calculated using third-party valuations. The key assumptions, which are generally unobservable inputs, used in the valuation of the mortgage servicing rights include mortgage prepayment rates, discount rates and delinquency rates. As of February 28, 2018, the key assumptions used in determining the fair value include a 11.6% mortgage prepayment rate, a 12.3% discount rate and a 6.1% delinquency rate. The fair value of mortgage servicing rights is included in the Lennar Financial Services segment's other assets.

The changes in fair values for Level 1 and Level 2 financial instruments measured on a recurring basis are shown below by financial instrument and financial statement line item:



	Three Months Ended
	February 28,
(In thousands)	2018			2017
Changes in fair value included in Lennar Financial Services revenues:
Loans held-for-sale	$	(16,297	)	13,300
Mortgage loan commitments	$	1,781		6,220
Forward contracts	$	3,163		(28,214	)
Changes in fair value included in Rialto revenues:
Financial Assets:
Credit default swaps	$	89		(431	)
Changes in fair value included in other comprehensive income (loss), net of tax:
Lennar Financial Services investment available-for-sale	$	(658	)	972

Interest on Lennar Financial Services loans held-for-sale and Rialto loans held-for-sale measured at fair value is calculated based on the interest rate of the loan and recorded as revenues in the Lennar Financial Services’ statement of operations and Rialto's statement of operations, respectively.

The following table represents the reconciliation of the beginning and ending balance for the Level 3 recurring fair value measurements:



	Three Months Ended February 28,
	2018					2017
	Lennar Financial Services			Rialto		Lennar Financial Services		Rialto
(In thousands)	Mortgage servicing rights			RMF loans held-for-sale		Mortgage servicing rights		RMF loans held-for-sale
Beginning balance	$	31,163		234,403		23,930		126,947
Purchases/loan originations	2,288			237,965		2,846		394,340
Sales/loan originations sold, including those not settled	—			(347,712	)	—		(477,716	)
Disposals/settlements	(1,213		)	—		(891	)	—
Changes in fair value (1)	4,534			753		612		1,420
Interest and principal paydowns	—			(2,011	)	—		(52	)
Ending balance	$	36,772		123,398		26,497		44,939


(1)	Changes in fair value for Rialto loans held-for-sale and Lennar Financial Services mortgage servicing rights are included in Rialto's and Lennar Financial Services' revenues, respectively.

The Company’s assets measured at fair value on a nonrecurring basis are those assets for which the Company has recorded valuation adjustments and write-offs. The fair values included in the table below represent only those assets whose carrying values were adjusted to fair value during the respective periods disclosed. The assets measured at fair value on a nonrecurring basis are summarized below:



		Three Months Ended February 28,
		2018					2017
(In thousands)	Fair Value Hierarchy	Carrying Value		Fair Value	Total Gains (Losses), Net (1)		Carrying Value	Fair Value	Total Losses, Net (1)
Financial assets
Rialto:
Impaired loans receivable	Level 3	$	—	—	—		31,550	18,885	(12,665	)
Non-financial assets
Lennar Homebuilding:
Land and land under development (2)	Level 3	$	52,929	43,565	(9,364	)	—	—	—
Rialto:
REO, net (3):
Upon acquisition/transfer	Level 3	$	—	—	—		8,850	8,394	(456	)
Upon management periodic valuations	Level 3	$	16,453	10,968	(5,485	)	52,425	40,096	(12,329	)


(1)	Represents losses due to valuation adjustments, write-offs, gains (losses) from transfers or acquisitions of real estate through foreclosure and REO impairments recorded during the three months ended February 28, 2018 and 2017.


(2)	Valuation adjustments were included in Lennar Homebuilding costs and expenses in the Company's condensed consolidated statement of operations for the three months ended February 28, 2018 and 2017.

(3)

The fair value of REO, net is based upon appraised value at the time of foreclosure or management's best estimate. In addition, management periodically performs valuations of its REO. The losses, net upon the transfer or acquisition of REO and impairments were included in Rialto other expense, net, in the Company’s condensed consolidated statement of operations for the three months ended February 28, 2018 and 2017.

Finished homes and construction in progress are included within inventories. Inventories are stated at cost unless the inventory within a community is determined to be impaired, in which case the impaired inventory is written down to fair value. The Company disclosed its accounting policy related to inventories and its review for indicators of impairment in the Summary of Significant Accounting Policies in its Form 10-K for the year ended November 30, 2017.

The Company estimates the fair value of inventory evaluated for impairment based on market conditions and assumptions made by management at the time the inventory is evaluated, which may differ materially from actual results if market conditions or assumptions change. For example, changes in market conditions and other specific developments or changes in assumptions may cause the Company to re-evaluate its strategy regarding previously impaired inventory, as well as inventory not currently impaired but for which indicators of impairment may arise if market deterioration occurs, and certain other assets that could result in further valuation adjustments and/or additional write-offs of option deposits and pre-acquisition costs due to abandonment of those options contracts.

On a quarterly basis, the Company reviews its active communities for indicators of potential impairments. As of February 28, 2018 and 2017, there were 1,340 and 750 active communities, excluding unconsolidated entities, respectively. As of February 28, 2018, the Company identified 20 communities with 1,184 homesites and a corresponding carrying value of $267.6 million as having potential indicators of impairment. For the three months ended February 28, 2018, the Company recorded a valuation adjustment of $6.9 million on 114 homesites in one community with a carrying value of $17.5 million.

As of February 28, 2017, the Company identified 16 communities with 589 homesites and a corresponding carrying value of $102.9 million as having potential indicators of impairment. For the three months ended February 28, 2017, the Company recorded no impairments.

The table below summarizes the most significant unobservable inputs used in the Company's discounted cash flow model to determine the fair value of its communities for which the Company recorded valuation adjustments during the three months ended February 28, 2018:



	Three Months Ended
	February 28, 2018
Unobservable inputs
Average selling price	$572,000
Absorption rate per quarter (homes)	6
Discount rate	20%

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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