Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2011

Fair Value of Financial Instruments

Note 5. Fair Value of Financial Instruments

For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to measure the fair value of the assets and liabilities. This hierarchy prioritizes relevant market inputs in order to determine an “exit price”, 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 at the date of measurement. Level 1 inputs are observable inputs that reflect quoted prices (unadjusted) 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 being 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 in 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. 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, 2011 and December 31, 2010.

	June 30, 2011				December 31, 2010
(In Thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Real estate loans (held-for-investment)
Residential loans – securitized	$	3,654,932	$	3,262,580	$	3,542,158	$	3,114,288
Residential loans – unsecuritized		203,465		207,086		253,082		253,052
Commercial loans – unsecuritized		71,168		71,200		30,536		30,887
Real estate loans (held-for-sale)		1,836		1,836		1,855		1,855
Commercial real estate loans (fair value)		12,698		12,698		19,850		19,850
Trading securities		296,978		296,978		329,717		329,717
Available-for-sale securities		740,623		740,623		825,119		825,119
Cash and cash equivalents		79,977		79,977		46,937		46,937
Derivative assets		4,013		4,013		8,051		8,051
Restricted cash		35,673		35,673		24,524		24,524
Accrued interest receivable		13,690		13,690		13,782		13,782
REO (included in other assets)		9,880		9,880		14,481		14,481
Liabilities
Short-term debt		40,891		40,891		44,137		44,137
Accrued interest payable		6,422		6,422		5,930		5,930
Derivative liabilities		82,639		82,639		83,115		83,115
ABS issued
ABS issued – Sequoia		3,566,001		3,085,586		3,458,501		2,959,997
ABS issued – Acacia		273,325		273,325		303,077		303,077
Total ABS issued		3,839,326		3,358,911		3,761,578		3,263,074
Long-term debt		139,500		78,120		139,500		75,330

We did not elect the fair value option for any financial instruments that we acquired in the first six months of 2011. We have elected the fair value option for all of the commercial loans, trading securities, and ABS issued at Acacia, as well as certain residential securities and CDOs at Redwood.

The following table presents assets and liabilities recorded at fair value on our consolidated balance sheet on a recurring basis and indicates the fair value hierarchy of the valuation techniques used to measure fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis at June 30, 2011

June 30, 2011 (In Thousands)	Carrying Value		Fair Value Measurements Using
			Level 1		Level 2		Level 3
Assets
Commercial real estate loans	$	12,698	$	—	$	—	$	12,698
Trading securities		296,978		—		—		296,978
Available-for-sale securities		740,623		—		—		740,623
Derivative assets		4,013		276		3,737		—
Liabilities
Derivative liabilities		82,639		1,425		81,214		—
ABS issued – Acacia		273,325		—		—		273,325

The following table presents additional information about Level 3 assets and liabilities for the six months ended June 30, 2011.

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

	Assets												Liabilities
(In Thousands)	Commercial Real Estate Loans			Trading Securities			AFS Securities			Derivative Assets			ABS Issued – Acacia
Beginning balance – December 31, 2010	$	19,850		$	329,717		$	825,119		$	1		$	303,077
Principal paydowns		(8,694	)		(30,261	)		(58,416	)		—			(42,873	)
Gains in net income, net		1,542			10,322			19,064			—			6,757
Losses in OCI, net		—			—			(28,170	)		—			—
Acquisitions		—			—			46,498			—			—
Sales		—			(13,035	)		(63,525	)		—			—
Other settlements, net		—			235			53			(1	)		6,364
Ending Balance – June 30, 2011	$	12,698		$	296,978		$	740,623		$	—		$	273,325

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 still held at June 30, 2011 and 2010. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and six months ended June 30, 2011 and 2010 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at June 30, 2011 and 2010 Included in Net Income

	Included in Net Income
	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2011			2010			2011			2010
Assets
Real estate loans	$	1,323		$	2,978		$	1,542		$	7,344
Trading securities		(9,557	)		5,042			1,070			17,364
Available-for-sale securities		(1,466	)		(4,216	)		(2,469	)		(6,134	)
Derivative assets		—			15			—			(5	)
Liabilities
Derivative liabilities		—			49			—			109
ABS issued – Acacia		17,380			11,257			(6,757	)		6,004

The following table presents information on assets and liabilities recorded at fair value on a non-recurring basis at June 30, 2011.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at June 30, 2011

									Gain (Loss)
	Carrying Value		Fair Value Measurements Using						Three Months Ended June 30, 2011			Six Months Ended June 30, 2011
(In Thousands)			Level 1		Level 2		Level 3
Assets
Real estate loans (held-for-sale)	$	1,836	$	—	$	—	$	1,836	$	8		$	11
REO		9,880		—		—		9,880		(244	)		(1,162	)

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the three and six months ended June 30, 2011 and 2010.

Market Valuation Adjustments, Net

	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2011			2010			2011			2010
Assets
Real estate loans (fair value)	$	1,323		$	2,978		$	1,542		$	7,344
Real estate loans (held-for-sale)		8			296			11			176
Trading securities		(9,594	)		6,330			10,322			18,479
REO		(244	)		(1,285	)		(1,162	)		(1,359	)
Impairments on AFS securities		(1,466	)		(4,216	)		(4,088	)		(6,162	)
Liabilities
ABS issued – Acacia		17,380			11,257			(6,757	)		6,004
Derivative instruments, net		(18,554	)		(22,485	)		(16,755	)		(42,844	)
Market Valuation Adjustments, Net	$	(11,147	)	$	(7,125	)	$	(16,887	)	$	(18,362	)

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 below.

• Real estate loans

• Residential real estate loan fair values are determined by available market quotes and discounted cash flow analyses (Level 3).

• Commercial real estate loan fair values are determined by available market quotes and discounted cash flow analyses (Level 3). The availability of market quotes for all of our commercial loans is limited. Any changes in fair value are primarily a result of instrument specific credit risk.

• Real estate securities

• Real estate securities are residential, commercial, CDO, and other asset-backed securities that are illiquid in nature and trade infrequently. Fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions that are confirmed by third-party dealer/pricing indications, to the extent available. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. Relevant market indicators that are factored in the analyses include bid/ask spreads, credit losses, interest rates, and prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3).

• We request and consider indications of value (marks) from third-party dealers to assist us in our valuation process. For June 30, 2011, we received dealer marks on 83% of our securities. In the aggregate, our internal valuations of the securities on which we received dealer marks were 3% lower (i.e., more conservative) than the aggregate dealer marks.

• Derivative assets and liabilities

• Our derivative instruments include interest rate agreements, TBAs, and financial futures. Fair values of derivative instruments are determined using quoted prices from active markets when available or valuation models and are verified by valuations provided by dealers active in derivative markets. TBA and financial futures fair values are generally obtained using quoted prices from active markets (Level 1). Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of such inputs. Model inputs for interest rate agreements can generally be verified and model selection does not involve significant management judgment (Level 2). For other derivatives, valuations are based on various factors such as liquidity, bid/offer spreads, and credit considerations for which we rely on available market evidence. In the absence of such evidence, management’s best estimate is used (Level 3).

• 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.

• Restricted cash

• Restricted cash primarily includes interest-earning cash balances in ABS entities and the Fund for the purpose of distribution to bondholders or limited partners, and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values.

• 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.

• Short-term debt

• Short-term debt includes our credit facilities that mature within one year. Short-term debt is generally at an adjustable rate. Fair values approximate carrying values.

• ABS issued

• ABS issued includes asset-backed securities issued through our Sequoia and Acacia programs. These instruments are illiquid in nature and trade infrequently, if at all. Fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions that are confirmed by third-party dealer/pricing indications, to the extent available. 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. Relevant market indicators factored into the analyses include dealer price indications to the extent available, bid/ask spreads, external spreads, collateral credit losses, interest rates and collateral prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3).

• We request and consider indications of value (marks) from third-party dealers to assist us in our valuation process. For June 30, 2011, we received dealer marks on 95% of our ABS issued. Our internal valuations of our ABS issued on which we received dealer marks were 7% higher (i.e., more conservative) than the aggregate dealer marks.

• Long-term debt

• Long-term debt includes our subordinated notes and trust preferred securities. Fair values are determined using comparable market indicators of current pricing. 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).

• 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).