Fair Value of Financial Instruments

For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to determine the fair value of financial instruments. This hierarchy prioritizes relevant market inputs in order to determine an “exit price” at the measurement date, or the price at which an asset could be sold or a liability could be transferred in an orderly process that is not a forced liquidation or distressed sale. Level 1 inputs are observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 inputs are observable inputs other than quoted prices for an asset or liability that are obtained through corroboration with observable market data. Level 3 inputs are unobservable inputs (e.g., our own data or assumptions) that are used when there is little, if any, relevant market activity for the asset or liability required to be measured at fair value.

In certain cases, inputs used to measure fair value fall into different levels of the fair value hierarchy. In such cases, the level at which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input requires judgment and considers factors specific to the asset or liability being measured.

The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value at December 31, 2017 and December 31, 2016.

Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities



	December 31, 2017				December 31, 2016
	Carrying Value		Fair Value		Carrying Value		Fair Value
(In Thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Residential loans, held-for-sale
At fair value	$	1,427,052	$	1,427,052	$	834,193	$	834,193
At lower of cost or fair value	893		993		1,206		1,365
Residential loans, held-for-investment
At fair value	3,687,265		3,687,265		3,052,652		3,052,652
Trading securities	968,844		968,844		445,687		445,687
Available-for-sale securities	507,666		507,666		572,752		572,752
MSRs	63,598		63,598		118,526		118,526
Cash and cash equivalents	144,663		144,663		212,844		212,844
Restricted cash	2,144		2,144		8,623		8,623
Accrued interest receivable	27,013		27,013		18,454		18,454
Derivative assets	15,718		15,718		36,595		36,595
REO ⁽¹⁾	3,354		3,806		5,533		5,560
Margin receivable⁽¹⁾	85,044		85,044		68,038		68,038
FHLBC stock ⁽¹⁾	43,393		43,393		43,393		43,393
Guarantee asset⁽¹⁾	2,869		2,869		4,092		4,092
Commercial loans⁽¹⁾	—		—		2,700		2,700
Pledged collateral⁽¹⁾	42,615		42,615		42,875		42,875
Liabilities
Short-term debt facilities	$	1,688,412	$	1,688,412	$	791,539	$	791,539
Accrued interest payable	18,435		18,435		9,608		9,608
Margin payable ⁽²⁾	390		390		12,783		12,783
Guarantee obligation ⁽²⁾	19,487		18,878		21,668		22,181
Derivative liabilities	63,081		63,081		66,329		66,329
ABS issued at fair value, net	1,164,585		1,164,585		773,462		773,462
FHLBC long-term borrowings	1,999,999		1,999,999		1,999,999		1,999,999
Convertible notes, net	686,759		692,369		482,195		493,365
Trust preferred securities and subordinated notes, net	138,535		103,230		138,489		96,255


(1)	These assets are included in Other assets on our consolidated balance sheets.


(2)	These liabilities are included in Accrued expenses and other liabilities on our consolidated balance sheets.

During the years ended December 31, 2017 and 2016, we elected the fair value option for $47 million and $5 million of residential senior securities, $594 million and $288 million of subordinate securities, $5.64 billion and $4.85 billion of residential loans (principal balance), and $8 million and $25 million of MSRs, respectively. We anticipate electing the fair value option for all future purchases of residential loans that we intend to sell to third parties or transfer to securitizations as well as for MSRs purchased or retained from sales of residential loans, and for certain securities we purchase, including IO securities and fixed-rate securities rated investment grade or higher.

The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis at December 31, 2017 and December 31, 2016, as well as the fair value hierarchy of the valuation inputs used to measure fair value.

Table 5.2 – Assets and Liabilities Measured at Fair Value on a Recurring Basis



December 31, 2017	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	5,114,317	$	—	$	—	$	5,114,317
Trading securities	968,844		—		—		968,844
Available-for-sale securities	507,666		—		—		507,666
Derivative assets	15,718		134		10,164		5,420
MSRs	63,598		—		—		63,598
Pledged collateral	42,615		42,615		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	2,869		—		—		2,869

Liabilities
Derivative liabilities	$	63,081	$	3,808	$	55,567	$	3,706
ABS issued	1,164,585		—		—		1,164,585



December 31, 2016	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	3,886,845	$	—	$	—	$	3,886,845
Trading securities	445,687		—		—		445,687
Available-for-sale securities	572,752		—		—		572,752
Derivative assets	36,595		8,300		24,980		3,315
MSRs	118,526		—		—		118,526
Pledged collateral	42,875		42,875		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	4,092		—		—		4,092

Liabilities
Derivative liabilities	$	66,329	$	5,609	$	56,919	$	3,801
ABS issued	773,462		—		—		773,462

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the years ended December 31, 2017 and 2016.

Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis



	Assets																		Liabilities
	Residential Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives ⁽¹⁾			ABS Issued
(In Thousands)	Residential Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives ⁽¹⁾			ABS Issued
Beginning balance - December 31, 2016	$	3,886,845		$	445,687		$	572,752		$	118,526		$	4,092		$	(486	)	$	773,462
Acquisitions	5,741,427			640,760			39,700			8,026			—			—			567,099
Sales	(3,982,683		)	(137,886		)	(90,440		)	(52,788		)	—			—			—
Principal paydowns	(573,168		)	(19,224		)	(58,554		)	—			—			—			(205,163		)
Gains (losses) in net income, net	46,119			39,507			31,892			(10,166		)	(1,223		)	37,220			29,187
Unrealized losses in OCI, net	—			—			12,316			—			—			—			—
Other settlements, net⁽²⁾	(4,223		)	—			—			—			—			(35,020		)	—
Ending balance - December 31, 2017	$	5,114,317		$	968,844		$	507,666		$	63,598		$	2,869		$	1,714		$	1,164,585



	Assets																					Liabilities
(In Thousands)	Residential Loans			Commercial Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives ⁽¹⁾			Commercial Secured Borrowings			ABS Issued
Beginning balance - December 31, 2015	$	3,797,551		$	106,798		$	404,011		$	829,245		$	191,976		$	5,697		$	3,208		$	63,152		$	996,820
Acquisitions	4,747,564			37,625			292,875			34,520			25,362			—			—			—			—
Sales	(3,813,538		)	(81,523		)	(244,219		)	(252,696		)	(62,440		)	—			—			—			—
Principal paydowns	(806,081		)	(476		)	(17,827		)	(62,229		)	—			—			—			(306		)	(208,215		)
Gains (losses) in net income, net	(33,893		)	2,791			10,847			48,399			(36,372		)	(1,605		)	30,193			2,369			(8,275		)
Unrealized gains in OCI, net	—			—			—			(24,487		)	—			—			—			—			—
Other settlements, net ⁽²⁾	(4,758		)	(65,215		)	—			—			—			—			(33,887		)	(65,215		)	(6,868		)
Ending balance - December 31, 2016	$	3,886,845		$	—		$	445,687		$	572,752		$	118,526		$	4,092		$	(486	)	$	—		$	773,462


(1)	For the purpose of this presentation, derivative assets and liabilities, which consist of loan purchase and forward sale commitments, are presented on a net basis.

(2)

Other settlements, net for residential loans represents the transfer of loans to REO, and for derivatives, the transfer of the fair value of loan purchase commitments at the time loans are acquired to the basis of residential loans. For commercial secured borrowings and commercial loans, the reduction in 2016 represents the derecognition of our commercial secured borrowings and related commercial A-note investments upon sale of the associated B-notes.

The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and held at December 31, 2017, 2016, and 2015. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the years ended December 31, 2017, 2016, and 2015 are not included in this presentation.

Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at December 31, 2017, 2016, and 2015 Included in Net Income



	Included in Net Income
	Years Ended December 31,
(In Thousands)	2017			2016			2015
Assets
Residential loans at Redwood	$	523		$	(17,370	)	$	(5,541	)
Residential loans at consolidated Sequoia entities	17,727			(14,391		)	7,422
Commercial loans	—			—			(2,620		)
Trading securities	28,612			7,184			(13,391		)
Available-for-sale securities	(1,011		)	(368		)	(246		)
MSRs	1,277			42,964			(3,471		)
Loan purchase commitments	3,243			—			4,252
Loan forward sale commitments	2,177			—			—
Other assets - Guarantee asset	(1,223		)	(1,605		)	(1,504		)

Liabilities
Loan purchase commitments	$	(3,706	)	$	(486	)	$	—
Commercial secured borrowing	—			—			3,011
ABS issued	(29,187		)	8,275			(8,366		)

The following table presents information on assets recorded at fair value on a non-recurring basis at December 31, 2017 and December 31, 2016. This table does not include the carrying value and gains or losses associated with the asset types below that were not recorded at fair value on our consolidated balance sheets at December 31, 2017 and December 31, 2016.

Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis



									Gain (Loss) for Year Ended
December 31, 2017	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		December 31, 2017
Assets
Residential loans, at lower of cost or fair value	$	854	$	—	$	—	$	854	$	22
REO	2,034		—		—		2,034		(393		)

									Gain (Loss) for Year Ended
December 31, 2016	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		December 31, 2016
Assets
Residential loans, at lower of cost or fair value	$	867	$	—	$	—	$	867	$	(17	)
Commercial loans, at lower of cost or fair value	2,700		—		—		2,700		(300		)
REO	5,207		—		—		5,207		(1,831		)

The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the years ended December 31, 2017, 2016, and 2015.

Table 5.6 – Market Valuation Gains and Losses, Net



	Years Ended December 31,
(In Thousands)	2017			2016			2015
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value	$	31,493		$	5,786		$	3,712
Residential loan purchase and forward sale commitments	37,880			25,613			50,234
Commercial loans, at fair value	—			433			10,265
Sequoia securities	—			1,455			(15,261		)
Risk management derivatives, net	(17,529		)	3,158			(42,468		)
Total mortgage banking activities, net ⁽¹⁾	$	51,844		$	36,445		$	6,482
Investment Fair Value Changes, Net
Residential loans held-for-investment at Redwood	$	(5,765	)	$	(23,102	)	$	(6,337	)
Trading securities	39,526			9,666			(2,019		)
Valuation adjustments on commercial loans held-for-sale	300			(307		)	—
Net investments in Legacy Sequoia entities ⁽²⁾	(8,027		)	(4,200		)	(1,192		)
Net investments in Sequoia Choice entities ⁽²⁾	(323		)	—			—
Risk-sharing investments	(1,484		)	(1,151		)	(1,886		)
Risk management derivatives, net	(12,842		)	(9,112		)	(9,677		)
Impairments on AFS securities	(1,011		)	(368		)	(246		)
Total investment fair value changes, net	$	10,374		$	(28,574	)	$	(21,357	)
MSR Income (Loss), Net
MSRs	$	(10,166	)	$	(36,372	)	$	(24,392	)
Risk management derivatives, net	(568		)	15,584			(12,708		)
Total MSR loss, net ⁽³⁾	$	(10,734	)	$	(20,788	)	$	(37,100	)
Total Market Valuation Gains (Losses), Net	$	51,484		$	(12,917	)	$	(51,975	)


(1)	Mortgage banking activities, net presented above does not include fee income or provisions for repurchases that are components of Mortgage banking activities, net presented on our consolidated statements of income, as these amounts do not represent market valuation changes.


(2)	Includes changes in fair value of the residential loans held-for-investment, REO and the ABS issued at the entities, which netted together represent the change in value of our retained investments at the consolidated VIEs.


(3)	MSR income (loss), net presented above does not include net fee income or provisions for repurchases that are components of MSR income (loss), net on our consolidated statements of income, as these amounts do not represent market valuation adjustments.

Valuation Policy

We maintain a policy that specifies the methodologies we use to value different types of financial instruments. Significant changes to the valuation methodologies are reviewed by members of senior management to confirm the changes are appropriate and reasonable. Valuations based on information from external sources are performed on an instrument-by-instrument basis with the resulting amounts analyzed individually against internal calculations as well as in the aggregate by product type classification. Initial valuations are performed by our portfolio management groups using the valuation processes described below. Our finance department then independently reviews all fair value estimates using available market, portfolio, and industry information to ensure they are reasonable. Finally, members of senior management review all fair value estimates, including an analysis of the methodology and valuation changes from prior reporting periods.

Valuation Process

We estimate fair values for financial assets or liabilities based on available inputs observed in the marketplace as well as unobservable inputs. We primarily use two pricing valuation techniques: market comparable pricing and discounted cash flow analysis. Market comparable pricing is used to determine the estimated fair value of certain instruments by incorporating known inputs and performance metrics, such as observed prepayment rates, delinquencies, severities, credit support, recent transaction prices, pending transactions, or prices of other similar instruments. Discounted cash flow analysis techniques generally consist of developing an estimate of future cash flows that are expected to occur over the life of an instrument and then discounting those cash flows at a rate of return that results in an estimate of fair value. After considering all available indications of the appropriate rate of return that market participants would require, we consider the reasonableness of the range indicated by the results to determine an estimate that is most representative of fair value. We also consider counterparty credit quality and risk as part of our fair value assessments.

The following table provides quantitative information about the significant unobservable inputs used in the valuation of our Level 3 assets and liabilities measured at fair value.

Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments



December 31, 2017	Fair Value			Input Values
(Dollars in Thousands, except Input Values)	Fair Value		Unobservable Input	Range						Weighted Average
Assets

Residential loans, at fair value:
Jumbo fixed rate loans	$	3,372,329	Whole loan spread to TBA price	$	2.25	-	$	3.11		$	3.09
			Whole loan spread to swap rate	175		-	225		bps	224		bps

Jumbo hybrid loans	251,847		Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate	100		-	185		bps	159		bps

Jumbo loans committed to sell	237,262		Whole loan committed sales price	$	100.78	-	$	103.01		$	101.42

Loans held by Legacy Sequoia ⁽¹⁾	632,817		Liability price				N/A			N/A

Loans held by Sequoia Choice ⁽¹⁾	620,062		Liability price				N/A			N/A

Residential loans, at lower of cost or fair value	854		Loss severity	12		-	30		%	18		%

Trading and AFS securities	1,476,510		Discount rate	3		-	15		%	5		%
			Prepayment rate (annual CPR)	—		-	50		%	10		%
			Default rate	—		-	27		%	3		%
			Loss severity	—		-	40		%	22		%

MSRs	63,598		Discount rate	10		-	130		%	11		%
			Prepayment rate (annual CPR)	5		-	26		%	9		%
			Per loan annual cost to service	$	79	-	$	82		$	82

Guarantee asset	2,869		Discount rate	11		-	11		%	11		%
			Prepayment rate (annual CPR)	13		-	13		%	13		%

REO	2,034		Loss severity	6		-	42		%	21		%

Liabilities

Loan purchase commitments, net ⁽²⁾	462		MSR multiple	1.7		-	5.1		x	3.6		x
			Pull-through rate	9		-	100		%	75		%
			Whole loan spread to TBA price	$	2.25	-	$	3.10		$	3.06
			Whole loan spread to swap rate - fixed rate	175		-	225		bps	225		bps
			Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate - hybrid	100		-	185		bps	151		bps

ABS issued ⁽¹⁾	1,164,585		Discount rate	3		-	15		%	4		%
			Prepayment rate (annual CPR)	8		-	25		%	17		%
			Default rate	—		-	16		%	3		%
			Loss severity	20		-	54		%	23		%


(1)	The fair value of the loans held by consolidated Sequoia entities was based on the fair value of the ABS issued by these entities, which we determined were more readily observable, in accordance with accounting guidance for collateralized financing entities.


(2)	For the purpose of this presentation, loan purchase commitment assets and liabilities are presented net.

Determination of Fair Value

A description of the instruments measured at fair value as well as the general classification of such instruments pursuant to the Level 1, Level 2, and Level 3 valuation hierarchy is listed herein. We generally use both market comparable information and discounted cash flow modeling techniques to determine the fair value of our Level 3 assets and liabilities. Use of these techniques requires determination of relevant inputs and assumptions, some of which represent significant unobservable inputs as indicated in the preceding table. Accordingly, a significant increase or decrease in any of these inputs – such as anticipated credit losses, prepayment rates, interest rates, or other valuation assumptions – in isolation would likely result in a significantly lower or higher fair value measurement.

Residential loans at Redwood

Estimated fair values for residential loans are determined using models that incorporate various observable inputs, including pricing information from whole loan sales and securitizations. Certain significant inputs in these models are considered unobservable and are therefore Level 3 in nature. Pricing inputs obtained from market whole loan transaction activity include indicative spreads to indexed TBA prices and indexed swap rates for fixed-rate loans and indexed swap rates for hybrid loans (Level 3). Pricing inputs obtained from market securitization activity include indicative spreads to indexed TBA prices for senior RMBS, indexed swap rates for subordinate RMBS, and credit support levels (Level 3). Other unobservable inputs also include assumed future prepayment rates. Observable inputs include benchmark interest rates, swap rates, and TBA prices. These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed, or credit support assumptions.

Residential loans at consolidated Sequoia entities

We have elected to account for the consolidated Sequoia securitization entities as collateralized financing entities in accordance with GAAP. A CFE is a variable interest entity that holds financial assets and issues beneficial interests in those assets, and these beneficial interests have contractual recourse only to the related assets of the CFE. Accounting guidance for CFEs allow companies to elect to measure both the financial assets and financial liabilities of a CFE using the more observable of the fair value of the financial assets or fair value of the financial liabilities. Pursuant to this guidance, we use the fair value of the ABS issued by the Sequoia CFEs (which we determined to be more observable) to determine the fair value of the loans held at these entities, whereby the net assets we consolidate in our financial statements related to these entities represent the estimated fair value of our retained interests in the Sequoia CFEs.

Real estate securities

Real estate securities include residential, commercial, and other asset-backed securities that are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators that are factored into the analysis include bid/ask spreads, the amount and timing of credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as a discount rate, prepayment rate, default rate, loss severity and credit support. The estimated fair value of our securities would generally decrease based upon an increase in default rates, loss severities, or a decrease in prepayment rates or credit support.

As part of our securities valuation process, we request and consider indications of value from third-party securities dealers. For purposes of pricing our securities at December 31, 2017, we received dealer price indications on 80% of our securities, representing 85% of our carrying value. In the aggregate, our internal valuations of the securities for which we received dealer price indications were within 1% of the aggregate average dealer valuations. Once we receive the price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are required to estimate fair value.

Derivative assets and liabilities

Our derivative instruments include swaps, swaptions, TBAs, financial futures, loan purchase commitments, and forward sale commitments. Fair values of derivative instruments are determined using quoted prices from active markets, when available, or from valuation models and are supported by valuations provided by dealers active in derivative markets. Fair values of TBAs and financial futures are generally obtained using quoted prices from active markets (Level 1). Our derivative valuation models for swaps and swaptions require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of certain inputs. Model inputs can generally be verified and model selection does not involve significant management judgment (Level 2).

LPC and FSC fair values for jumbo loans are estimated based on the estimated fair values of the underlying loans (as described in "Residential loans" above). In addition, fair value for LPCs are estimated based on the probability that the mortgage loan will be purchased (the "Pull-through rate") (Level 3).

For other derivatives, valuations are based on various factors such as liquidity, bid/ask spreads, and credit considerations for which we rely on available market inputs. In the absence of such inputs, management’s best estimate is used (Level 3).

MSRs

MSRs include the rights to service jumbo and conforming residential mortgage loans. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Changes in the fair value of MSRs occur primarily due to the collection/realization of expected cash flows, as well as changes in valuation inputs and assumptions. Estimated fair values are based on applying the inputs to generate the net present value of estimated future MSR income (Level 3). These discounted cash flow models utilize certain significant unobservable inputs including market discount rates, assumed future prepayment rates of serviced loans, and the market cost of servicing. An increase in these unobservable inputs would generally reduce the estimated fair value of the MSRs.

As part of our MSR valuation process, we received a valuation estimate from a third-party valuations firm. In the aggregate, our internal valuation of the MSRs were within 2% of the third-party valuation.

FHLBC Stock

Our Federal Home Loan Bank ("FHLB") member subsidiary is required to purchase Federal Home Loan Bank of Chicago ("FHLBC") stock under a borrowing agreement between our FHLB-member subsidiary and the FHLBC. Under this agreement, the stock is redeemable at face value, which represents the carrying value and fair value of the stock (Level 2).

Guarantee Asset

The guarantee asset represents the estimated fair value of cash flows we are contractually entitled to receive related to a risk-sharing arrangement with Fannie Mae. Significant inputs in the valuation analysis are Level 3, due to the nature of this asset and the lack of market quotes. The fair value of the guarantee asset is determined using a discounted cash flow model, for which significant unobservable inputs include assumed future prepayment rates and market discount rate (Level 3). An increase in prepayment rates or discount rate would generally reduce the estimated fair value of the guarantee asset.

Pledged Collateral

Pledged collateral consists of cash and U.S. Treasury securities held by a custodian in association with certain agreements we have entered into. Treasury securities are carried at their fair value, which is determined using quoted prices in active markets (Level 1).

Cash and cash equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values (Level 1).

Restricted cash

Restricted cash primarily includes interest-earning cash balances related to risk-sharing transactions with the Agencies, cash held in association with borrowings from the FHLBC, and cash held at consolidated Sequoia entities for the purpose of distribution to investors and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values (Level 1).

Accrued interest receivable and payable

Accrued interest receivable and payable includes interest due on our assets and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values (Level 1).

REO

REO includes properties owned in satisfaction of foreclosed loans. Fair values are determined using available market quotes, appraisals, broker price opinions, comparable properties, or other indications of value (Level 3).

Margin receivable

Margin receivable reflects cash collateral we have posted with our various derivative and debt counterparties as required to satisfy margin requirements. Fair values approximate carrying values (Level 2).

Guarantee Obligations

In association with our risk-sharing transactions with the Agencies, we have made certain guarantees. These obligations are initially recorded at fair value and subsequently carried at amortized cost. Fair values of guarantee obligations are determined using internal models that incorporate certain significant inputs that are considered unobservable and are therefore Level 3 in nature. Pricing inputs include assumed future prepayment rates, credit losses, and market discount rates. A decrease in future prepayment rates or discount rates, or an increase in credit losses, would generally cause the fair value of the guarantee obligations to decrease (i.e., become a larger liability).

Short-term debt

Short-term debt includes our credit facilities that mature within one year. As these borrowings are secured and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2). Additionally, at December 31, 2017, short-term debt included unsecured convertible senior notes with a maturity of less than one year. The fair value of the convertible notes is determined using quoted prices in generally active markets (Level 2).

ABS issued

ABS issued includes asset-backed securities issued through the Legacy Sequoia and Sequoia Choice securitization entities. These instruments are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. For ABS issued, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators factored into the analysis include bid/ask spreads, the amount and timing of collateral credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as a discount rate, prepayment rate, default rate, loss severity and credit support. A decrease in credit losses or discount rates, or an increase in prepayment rates, would generally cause the fair value of the ABS issued to decrease (i.e., become a larger liability).

FHLBC Borrowings

FHLBC borrowings include amounts borrowed from the FHLBC that are secured, generally by residential mortgage loans. As these borrowings are secured and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2).

Convertible notes

Convertible notes include unsecured convertible and exchangeable senior notes. Fair values are determined using quoted prices in generally active markets (Level 2).

Trust preferred securities and subordinated notes

Estimated fair values of trust preferred securities and subordinated notes are determined using discounted cash flow analysis valuation techniques. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3).