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Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2020

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 June 30, 2020 and December 31, 2019.

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


	June 30, 2020						December 31, 2019
	Carrying Value		Fair Value		Carrying Value		Fair Value
(In Thousands)
Assets
Residential loans, held-for-sale at fair value	$	20,098	$	20,098	$	536,385	$	536,509
Residential loans, held-for-investment	4,514,131		4,514,131		7,178,465		7,178,465
Business purpose residential loans, held-for-sale	379,795		379,795		331,565		331,565
Business purpose residential loans, held-for-investment	3,402,405		3,402,405		3,175,178		3,175,178
Multifamily loans	489,075		489,075		4,408,524		4,408,524

Trading securities	142,699		142,699		860,540		860,540
Available-for-sale securities	173,737		173,737		239,334		239,334
Servicer advance investments ⁽¹⁾	266,948		266,948		169,204		169,204
MSRs ⁽¹⁾	19,661		19,661		42,224		42,224

Excess MSRs ⁽¹⁾	36,197		36,197		31,814		31,814
Shared home appreciation options⁽¹⁾	40,851		40,851		45,085		45,085
Cash and cash equivalents	528,612		528,612		196,966		196,966
Restricted cash	44,496		44,496		93,867		93,867
Accrued interest receivable	44,134		44,134		71,058		71,058
Derivative assets	357		357		35,701		35,701
REO ⁽²⁾	9,780		10,014		9,462		10,389
Margin receivable⁽²⁾	2,746		2,746		209,776		209,776
FHLBC stock ⁽²⁾	5,000		5,000		43,393		43,393
Guarantee asset⁽²⁾	770		770		1,686		1,686

Pledged collateral⁽²⁾	33,105		33,105		32,945		32,945
Liabilities
Short-term debt facilities	$	418,370	$	418,370	$	2,176,591	$	2,176,591
Short-term debt - servicer advance financing	244,437		244,437		152,554		152,554
Accrued interest payable	37,024		37,024		60,655		60,655
Margin payable ⁽³⁾	—		—		1,700		1,700
Guarantee obligation ⁽³⁾	12,350		10,995		14,009		13,754
Contingent consideration ⁽³⁾	14,953		14,953		28,484		28,484
Derivative liabilities	1,932		1,932		163,424		163,424
ABS issued at fair value	6,856,086		6,856,086		10,515,475		10,515,475
FHLBC long-term borrowings	1,000		1,000		1,999,999		1,999,999
Other long-term debt, net	1,088,609		1,082,327		183,520		184,666
Convertible notes, net	509,868		469,360		631,125		661,985
Trust preferred securities and subordinated notes, net	138,651		55,800		138,628		99,045

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

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

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

During the three and six months ended June 30, 2020, we elected the fair value option for $10 million and $78 million of securities, respectively, $58 million and $2.69 billion of residential loans (principal balance), respectively, $230 million and $696 million of business purpose residential loans (principal balance), respectively, $21 million and $179 million of servicer advance investments, respectively, $2 million and $11 million of excess MSRs, respectively, and zero and $4 million of shared home appreciation options, respectively. We anticipate electing the fair value option for all future purchases of residential and business purpose residential loans that we intend to sell to third parties or transfer to securitizations, as well as 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 June 30, 2020 and December 31, 2019, 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


June 30, 2020	Carrying Value		Fair Value Measurements Using
(In Thousands)					Level 1			Level 2			Level 3
Assets
Residential loans	$	4,534,229	$	—		$	—		$	4,534,229
Business purpose residential loans	3,782,200		—			—			3,782,200
Multifamily loans	489,075		—			—			489,075
Trading securities	142,699		—			—			142,699
Available-for-sale securities	173,737		—			—			173,737
Servicer advance investments	266,948		—			—			266,948
MSRs	19,661		—			—			19,661
Excess MSRs	36,197		—			—			36,197
Shared home appreciation options	40,851		—			—			40,851
Derivative assets	357		—			—			357
Pledged collateral	33,105		33,105			—			—
FHLBC stock	5,000		—			5,000			—
Guarantee asset	770		—			—			770

Liabilities

Derivative liabilities	$	1,932	$	—		$	—		$	1,932

ABS issued	6,856,086		—			—			6,856,086


December 31, 2019	Carrying Value		Fair Value Measurements Using
(In Thousands)					Level 1			Level 2			Level 3
Assets
Residential loans	$	7,714,745	$	—		$	—		$	7,714,745
Business purpose residential loans	3,506,743		—			—			3,506,743
Multifamily loans	4,408,524		—			—			4,408,524
Trading securities	860,540		—			—			860,540
Available-for-sale securities	239,334		—			—			239,334
Servicer advance investments	169,204		—			—			169,204
MSRs	42,224		—			—			42,224
Excess MSRs	31,814		—			—			31,814
Shared home appreciation options	45,085		—			—			45,085
Derivative assets	35,701		6,531			19,020			10,150
Pledged collateral	32,945		32,945			—			—
FHLBC stock	43,393		—			43,393			—
Guarantee asset	1,686		—			—			1,686

Liabilities
Contingent consideration	$	28,484	$	—		$	—		$	28,484
Derivative liabilities	163,424		13,368			148,766			1,290

ABS issued	10,515,475		—			—			10,515,475

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the six months ended June 30, 2020.

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


	Assets
	Residential Loans		Business Purpose Residential Loans		Multifamily Loans		Trading Securities		AFS Securities		Servicer Advance Investments		MSRs		Excess MSRs		Shared Home Appreciation Options
(In Thousands)
Beginning balance - December 31, 2019	$	7,714,745	$	3,506,743	$	4,408,524	$	860,540	$	239,334	$	169,204	$	42,224	$	31,814	$	45,085

Acquisitions	2,751,590		—		—		77,889		31,181		179,419		—		10,906		3,517
Originations	—		721,054		—		—		—		—		—		—		—
Sales	(4,695,048)		(44,172)		—		(566,537)		(55,193)		—		—		—		—
Principal paydowns	(907,360)		(272,052)		(5,830)		(8,114)		(8,293)		(75,477)		—		—		(1,080)
Deconsolidations	—		—		(3,849,779)		—		—		—		—		—		—
Gains (losses) in net income (loss), net	(328,313)		(121,961)		(63,840)		(221,079)		(33,292)		(6,198)		(22,563)		(6,523)		(6,671)

Other settlements, net ⁽¹⁾	(1,385)		(7,412)		—		—		—		—		—		—		—
Ending balance - June 30, 2020	$	4,534,229	$	3,782,200	$	489,075	$	142,699	$	173,737	$	266,948	$	19,661	$	36,197	$	40,851

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


	Assets				Liabilities
	Guarantee Asset		Derivatives ⁽²⁾		Contingent Consideration		ABS Issued
(In Thousands)
Beginning balance - December 31, 2019	$	1,686	$	8,860	$	28,484	$	10,515,475

Acquisitions	—		—		—		827,645

Principal paydowns	—		—		(13,353)		(673,324)
Deconsolidations	—		—		—		(3,706,789)
Gains (losses) in net income (loss), net	(916)		20,643		(446)		(106,921)

Other settlements, net ⁽¹⁾	—		(31,078)		(14,685)		—
Ending balance - June 30, 2020	$	770	$	(1,575)	$	—	$	6,856,086

(1) Other settlements, net for residential and business purpose residential loans represents the transfer of loans to REO, and for derivatives, the settlement of forward sale commitments and the transfer of the fair value of loan purchase or interest rate lock commitments at the time loans are acquired to the basis of residential and single-family rental loans. Other settlements, net for contingent consideration reflects the reclassification from a contingent liability to a deferred liability during the period due to an amendment in the underlying agreement. See Note 16 for further discussion.

(2) For the purpose of this presentation, derivative assets and liabilities, which consist of loan purchase commitments and interest rate lock commitments, are presented on a net basis.

The following table presents the portion of gains or losses included in our consolidated statements of income (loss) that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and held at June 30, 2020 and 2019. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and six months ended June 30, 2020 and 2019 are not included in this presentation.

Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at June 30, 2020 and 2019 Included in Net Income


	Included in Net Income
	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2020		2019		2020		2019
Assets
Residential loans at Redwood	$	(359)	$	48,575	$	(746)	$	80,615
Business purpose residential loans	31,187		3,038		(21,026)		4,032
Net investments in consolidated Sequoia entities ⁽¹⁾	39,558		2,487		(30,502)		5,191
Net investments in consolidated Freddie Mac SLST entities ⁽¹⁾	26,867		8,037		(115,295)		14,402
Net investments in consolidated Freddie Mac K-Series entities ⁽¹⁾	1,599		3,246		(13,180)		6,365
Net investments in consolidated CAFL entities ⁽¹⁾	17,125		—		(50,721)		—
Trading securities	30,647		17,771		(79,633)		38,658

Servicer advance investments	(136)		432		(6,198)		1,440
MSRs	(1,591)		(7,334)		(16,507)		(11,518)
Excess MSRs	2,971		(66)		(6,523)		(502)
Shared home appreciation options	884		—		(6,670)		—
Loan purchase and interest rate lock commitments	357		5,534		357		5,567

Other assets - Guarantee asset	(135)		(277)		(916)		(196)

Liabilities
Loan purchase commitments	$	2,137	$	(756)	$	(1,634)	$	(772)

(1) Represents the portion of net gains or losses included in our consolidated statements of income (loss) related to loans and the associated ABS issued at our consolidated securitization entities held at June 30, 2020 and 2019, which netted together represent the change in value of our investments at the consolidated VIEs.

The following table presents information on assets recorded at fair value on a non-recurring basis at June 30, 2020. 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 June 30, 2020.

Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at June 30, 2020


												Gain (Loss) for
June 30, 2020	Carrying Value		Fair Value Measurements Using															Three Months Ended	Six Months Ended
(In Thousands)					Level 1			Level 2			Level 3			June 30, 2020			June 30, 2020
Assets


REO	$	1,712	$	—		$	—		$	1,712		$	(36)		$	(31)

The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the three and six months ended June 30, 2020 and 2019.

Table 5.6 – Market Valuation Gains and Losses, Net


	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2020		2019		2020		2019
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value	$	(2,014)	$	3,379	$	(15,494)	$	6,912
Residential loan purchase and forward sale commitments	621		16,888		22,056		28,199
Single-family rental loans held-for-sale, at fair value	1,210		1,313		12,677		2,917
Single-family rental loan purchase and interest rate lock commitments	—		569		341		709
Residential bridge loans	(1,260)		1,012		(5,194)		1,098
Risk management derivatives, net	—		(7,431)		(52,832)		(12,415)
Total mortgage banking activities, net ⁽¹⁾	$	(1,443)	$	15,730	$	(38,446)	$	27,420
Investment Fair Value Changes, Net
Residential loans held-for-investment, at Redwood	$	104	$	35,548	$	(93,532)	$	63,656
Single-family rental loans held-for-investment	2,222		—		(20,806)		—
Residential bridge loans held-for-investment	21,774		(318)		(16,828)		(621)
Trading securities	42,246		18,442		(221,079)		40,302
Servicer advance investments	(136)		432		(6,198)		1,440
Excess MSRs	2,971		(65)		(6,523)		(502)


Net investments in Legacy Sequoia entities ⁽²⁾	(230)		(123)		(621)		(497)
Net investments in Sequoia Choice entities ⁽²⁾	39,753		2,879		(29,916)		6,144
Net investments in Freddie Mac SLST entities ⁽²⁾	26,867		8,037		(115,295)		14,402
Net investments in Freddie Mac K-Series entities ⁽²⁾	1,599		3,246		(84,910)		6,365
Net investments in CAFL entities ⁽²⁾	17,125		—		(50,721)		—
Other investments	(2,121)		(200)		(11,562)		(277)
Risk management derivatives, net	—		(64,740)		(59,142)		(107,115)

Credit recoveries (losses) on AFS securities	54		—		(1,471)		—
Total investment fair value changes, net	$	152,228	$	3,138	$	(718,604)	$	23,297
Other Income
MSRs	$	(3,955)	$	(8,653)	$	(22,563)	$	(13,753)
Risk management derivatives, net	—		6,517		13,966		8,768
Gain on re-measurement of 5 Arches investment	—		—		—		2,440
Total other income ⁽³⁾	$	(3,955)	$	(2,136)	$	(8,597)	$	(2,545)
Total Market Valuation Gains (Losses), Net	$	146,830	$	16,732	$	(765,647)	$	48,172

(1)Mortgage banking activities, net presented above does not include fee income from loan originations or acquisitions, provisions for repurchases expense, and other expenses that are components of Mortgage banking activities, net presented on our consolidated statements of income (loss), 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 investments at the consolidated VIEs.

(3)Other income presented above does not include net MSR fee income or provisions for repurchases for MSRs, as these amounts do not represent market valuation adjustments.

At June 30, 2020, our valuation policy and processes had not changed from those described in our Annual Report on Form 10-K for the year ended December 31, 2019. 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


June 30, 2020	Fair Value				Input Values
(Dollars in Thousands, except Input Values)				Unobservable Input			Range							Weighted Average⁽⁵⁾
Assets
Residential loans, at fair value:









Jumbo loans committed to sell	$	20,199	Whole loan committed sales price		$	101.00	-	$	101.00		$	101.00






Loans held by Legacy Sequoia ⁽¹⁾	304,632		Liability price					N/A			N/A

Loans held by Sequoia Choice ⁽¹⁾	2,064,388		Liability price					N/A			N/A

Loans held by Freddie Mac SLST ⁽¹⁾	2,145,111		Liability price					N/A			N/A

Business purpose residential loans:
Single-family rental loans	379,795		Senior credit spread		230		-	230		bps	230		bps
			Subordinate credit spread		300		-	2,450		bps	772		bps
			Senior credit support		31		-	36		%	34		%
			IO discount rate		10		-	10		%	10		%
			Prepayment rate (annual CPR)		3		-	3		%	3		%

Single-family rental loans held by CAFL	2,615,038		Liability price					N/A			N/A

Residential bridge loans	787,367		Discount rate		8		-	17		%	11		%

Multifamily loans held by Freddie Mac K-Series ⁽¹⁾	489,075		Liability price					N/A			N/A



Trading and AFS securities	316,436		Discount rate		4		-	21		%	10		%
			Prepayment rate (annual CPR)		6		-	65		%	17		%
			Default rate		—		-	15		%	1		%
			Loss severity		—		-	50		%	16		%

Servicer advance investments	266,948		Discount rate		5		-	5		%	5		%
			Prepayment rate (annual CPR)		8		-	14		%	14		%
			Expected remaining life ⁽²⁾		2		-	2		years	2		years
			Mortgage servicing income		8		-	13		bps	10		bps

MSRs	19,661		Discount rate		12		-	12		%	12		%
			Prepayment rate (annual CPR)		8		-	62		%	21		%
			Per loan annual cost to service		$	95	-	$	95		$	95

Excess MSRs	36,197		Discount rate		15		-	20		%	18		%
			Prepayment rate (annual CPR)		10		-	14		%	12		%
			Excess mortgage servicing income		9		-	17		bps	12		bps

Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments (continued)


June 30, 2020	Fair Value				Input Values
(Dollars in Thousands, except Input Values)				Unobservable Input			Range							Weighted Average ⁽⁴⁾
Assets (continued)
















































Shared home appreciation options	$	40,851	Discount rate		17		-	17		%	17		%
			Prepayment rate (annual CPR)		8		-	28		%	21		%
			Home price appreciation		1		-	3		%	3		%

Guarantee asset	781		Discount rate		13		-	13		%	13		%
			Prepayment rate (annual CPR)		37		-	37		%	37		%

REO	1,712		Loss severity		3		-	86		%	19		%








Liabilities
Residential loan purchase commitments, net	177		Committed sales price		$	96.10	-	$	101.28		$	100.11

			Pull-through rate		100		-	100		%	100		%





ABS issued ⁽¹⁾:
At consolidated Sequoia entities	2,162,134		Discount rate		2		-	25		%	4		%
			Prepayment rate (annual CPR)		10		-	50		%	24		%
			Default rate		—		-	40		%	1		%
			Loss severity		—		-	50		%	32		%

At consolidated Freddie Mac SLST entities	1,812,008		Discount rate		2		-	14		%	4		%
			Prepayment rate (annual CPR)		6		-	6		%	6		%
			Default rate		17		-	18		%	17		%
			Loss severity		30		-	30		%	30		%

At consolidated Freddie Mac K-Series entities ⁽³⁾	464,691		Discount rate		1		-	19		%	2		%
			Non-IO prepayment rate (annual CPR)		—		-	—		%	—		%
			IO prepayment rate (annual CPY/CPP)		100		-	100		%	100		%



At consolidated CAFL entities ⁽³⁾	2,417,253		Discount rate		1		-	74		%	4		%
			Prepayment rate (annual CPR)		—		-	3		%	—		%

(1)The fair value of the loans held by consolidated entities was based on the fair value of the ABS issued by these entities, including securities we own, which we determined were more readily observable, in accordance with accounting guidance for collateralized financing entities. At June 30, 2020, the fair value of securities we owned at the consolidated Sequoia, Freddie Mac SLST, Freddie Mac K-Series, and CAFL entities was $208 million, $334 million, $24 million, and $203 million, respectively.

(2)Represents the estimated average duration of outstanding servicer advances at a given point in time (not taking into account new advances made with respect to the pool).

(3)As a market convention, certain securities are priced to a no-loss yield and therefore do not include default and loss severity assumptions.

(4)The weighted average input values for all loan types are based on the unpaid principal balance. The weighted average input values for all other assets and liabilities are based on relative fair value.

Determination of Fair Value

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 input 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.

Included in Note 5 to the Consolidated Financial Statements of our Annual Report on Form 10-K for the year ended December 31, 2019 is a more detailed description of our financial instruments measured at fair value and their significant inputs, as well as the general classification of such instruments pursuant to the Level 1, Level 2, and Level 3 valuation hierarchy.

- 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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