Note 5. 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 September 30, 2013 and December 31, 2012.


	September 30, 2013				December 31, 2012
(In Thousands)	Carrying		Fair		Carrying		Fair
(In Thousands)	Value		Value		Value		Value
Assets
Residential loans, held-for-sale
At fair value	$	726,161	$	726,161	$	553,576	$	553,576
At lower of cost or fair value		1,718		1,794		9,082		9,324
Residential loans, held-for-investment		1,864,653		1,690,898		2,272,812		2,062,352
Commercial loans, held-for-sale
At fair value		27,413		27,413		-		-
At lower of cost or fair value		-		-		8,500		8,500
Commercial loans, held-for-investment		352,440		357,077		304,510		309,547
Trading securities		130,854		130,854		33,172		33,172
Available-for-sale securities		1,193,824		1,193,824		1,075,581		1,075,581
Mortgage servicing rights		60,234		60,234		5,315		5,315
Cash and cash equivalents		204,646		204,646		81,080		81,080
Restricted cash		417		417		383		383
Accrued interest receivable		14,523		14,523		12,442		12,442
Derivative assets		4,852		4,852		2,972		2,972
REO ⁽¹⁾		4,050		4,728		4,245		5,540
Margin receivable ⁽¹⁾		46,970		46,970		63,424		63,424
Other collateral posted ⁽¹⁾		5,000		5,000		-		-

Liabilities
Short-term debt	$	838,299	$	838,299	$	551,918	$	551,918
Accrued interest payable		11,162		11,162		4,592		4,592
Derivative liabilities		32,697		32,697		51,081		51,081
ABS issued		2,061,665		1,853,161		2,529,941		2,372,971
Commercial borrowings		44,605		44,605		-		-
Convertible notes		287,500		283,547		-		-
Other long-term debt		139,500		104,625		139,500		90,675

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

We elected the fair value option for $9 million and $101 million of residential senior securities, $4 million and $4 million of residential subordinate securities and $1.28 billion and $6.35 billion of residential loans (principal balance) that we acquired during the three and nine months ended September 30, 2013, respectively. We also elected the fair value option for $113 million and $263 million of commercial senior loans we acquired during the three and nine months ended September 30, 2013, respectively. We anticipate electing the fair value option for residential senior IO securities and all future purchases of loans that we intend to sell to third parties or transfer to Sequoia securitizations. We have historically elected the fair value option for certain commercial loans and trading securities, as well as certain third-party residential securities.

The following table presents the assets and liabilities recorded that are reported at fair value on our consolidated balance sheets on a recurring basis at September 30, 2013, as well as the fair value hierarchy of the valuation inputs used to measure fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis at September 30, 2013


September 30, 2013	Carrying		Fair Value Measurements Using
(In Thousands)	Value		Level 1		Level 2		Level 3
Assets
Residential loans, at fair value	$	726,161	$	-	$	-	$	726,161
Commercial loans, at fair value		27,413		-		-		27,413
Trading securities		130,854		-		-		130,854
Available-for-sale securities		1,193,824		-		-		1,193,824
MSRs		60,234		-		-		60,234
Derivative assets		4,852		745		4,107		-

Liabilities
Derivative liabilities		32,697		6,341		26,356		-

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2013.

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


	Assets
(In Thousands)	Residential Loans		Commercial Loans		Trading Securities		AFS Securities		MSRs
Beginning balance - December 31, 2012	$	553,576	$	0	$	33,172	$	1,075,581	$	5,315
Principal paydowns		(6,675)		(109)		(1,240)		(122,789)		-
(Losses) gains in net income, net		(40,307)		2,818		34,380		45,824		9,628
Unrealized losses in OCI, net		-		-		-		(48,823)		-
Acquisitions		6,448,724		262,806		104,552		417,251		45,291
Sales		(6,228,242)		(238,102)		(40,010)		(173,220)		-
Other settlements, net		(915)		-		-		-		-

Ending Balance - September 30, 2013	$	726,161	$	27,413	$	130,854	$	1,193,824	$	60,234

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 September 30, 2013 and 2012. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and nine months ended September 30, 2013 and 2012 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at September 30, 2013 and 2012 Included in Net Income


	Included in Net Income
	Three Months Ended September 30,				Nine Months Ended September 30,
(In Thousands)	2013		2012		2013		2012
Assets
Residential loans, at fair value	$	(1,864)	$	11,662	$	(3,088)	$	11,662
Commercial loans, at fair value		831		11		831		134
Trading securities		(1,525)		28,937		28,491		71,136
Available-for-sale securities		-		(1,207)		(940)		(1,842)
MSRs		1,344		(578)		12,561		(1,029)

Liabilities
Derivative liabilities		-		(2,304)		-		(3,394)
ABS issued - Acacia		-		(28,167)		-		(73,193)

The following table presents information on assets recorded at fair value on a non-recurring basis at September 30, 2013. 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 balance sheet at September 30, 2013.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at September 30, 2013


									Gain (Loss) for
September 30, 2013	Carrying		Fair Value Measurements Using						Three Months Ended		Nine Months Ended
(In Thousands)	Value		Level 1		Level 2		Level 3		September 30, 2013		September 30, 2013
Assets
Residential loans, at lower of cost or fair value	$	1,116	$	-	$	-	$	1,116	$	(13)	$	29
REO		1,305		-		-		1,305		30		(367)

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the three and nine months ended September 30, 2013 and 2012.

Market Valuation Adjustments, Net


	Three Months Ended September 30,				Nine Months Ended September 30,
(In Thousands)	2013		2012		2013		2012
Other
Residential loans, at lower of cost or fair value	$	(11)	$	90	$	68	$	572
Commercial loans, at fair value		-		11		-		134
Trading securities		540		35,099		(4,168)		84,923
Impairments on AFS securities		-		(1,207)		(1,666)		(1,842)
REO		(76)		(220)		(407)		(364)
Other derivative instruments, net		9		(4,649)		74		(10,632)
ABS issued—Acacia		-		(28,167)		-		(73,193)

Total other		462		957		(6,099)		(402)

Mortgage banking activities
Residential loans, at fair value		(10,804)		14,976		(17,339)		14,992
Commercial loans, at fair value		3,171		-		2,826		-
Trading securities		(1,866)		(4,427)		36,399		(9,101)
MSRs		460		(650)		9,629		(1,194)
Derivative instruments, net		442		(2,385)		51,009		(8,784)

Total mortgage banking activities		(8,597)		7,514		82,524		(4,087)

Total Market Valuation Adjustments, Net	$	(8,135)	$	8,471	$	76,425	$	(4,489)

Valuation Policy

We maintain a policy that specifies the methodology we use to value different types of financial instruments. Significant changes to the valuation methodology 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 group using the valuation process described below. A subset of 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 valuation changes from prior reporting periods.

Valuation Process

We estimate fair values for financial assets or liabilities based on available observable and unobservable inputs observed in the marketplace. 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, 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.

Fair Value Methodology for Level 3 Financial Instruments


September 30, 2013 (Dollars in Thousands)	Fair Value		Unobservable Input	Range		Weighted Average
Assets
Residential loans, at fair value:
Loans priced to securitization	$	230,465	Discount rate		4 - 4 %		4 %
			Prepayment rate		15 -15 %		15 %
			Default rate		1 - 1 %		1 %
			Loss severity		22 - 22 %		22 %
			Credit support		8 - 8 %		8 %

Loans priced to whole loan market and committed to sell		401,009	Pool fallout assumption		0 - 0 %		- %

Loans priced to whole loan market and uncommitted to sell		94,688	Base Price		101.5 - 101.5 %		101.5 %
			Base Coupon		3.2 - 4.1 %		3.9 %
			Buy up (x coupon difference from base coupon)		2 - 2 x		2 x
			Buy Down (x coupon difference from base coupon)		3 - 3 x		3 x

Residential loans, at lower of cost or fair value		1,116	Loss severity		15-28 %		21 %

Commercial loans, held for sale		27,413	Credit Spread		161 bps - 161 bps		161 bps
			Credit Support		20 - 20 %		20 %

Trading and AFS securities		1,324,678	Discount rate		5 - 13 %		7 %
			Prepayment speed		1 - 40 %		13 %
			Default rate		0 - 35 %		8 %
			Loss severity		20 - 66 %		32 %
			Credit support		0 - 61 %		5 %

MSRs		60,234	Discount rate		9 - 11 %		11 %
			Prepayment rate		6 - 60 %		9 %

REO		1,305	Historical loss adjustment		0 - 40 %		15 %

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 speeds, interest rates, or other valuation assumptions – in isolation, would likely result in a significantly lower or higher fair value measurement.

Residential loans

Estimated fair values for residential loans are determined based on either an exit price to securitization or the whole loan market. For loans valued based on an exit to securitization, significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the limited availability of market quotes on newly issued Residential Mortgage-Backed Securities (“RMBS”) and related inputs. Relevant market indicators that are factored into the analyses include third-party RMBS sales, pricing points for secondary sales of RMBS we have issued in past periods, yields for RMBS issued by government sponsored enterprises, indexed swap yields, credit rating agency guidance on expected credit enhancement levels for newly issued RMBS transactions, interest rates, and prepayment speeds (Level 3).

For loans valued based on an exit to the whole loan market, significant inputs in the valuation analysis are predominantly Level 3 in nature. Relevant market indicators that are factored into the analyses include prices on recent sales of our own whole loans, indexed swap yields, interest rates, prepayment speeds, and loss severities (Level 3). These assets would generally decrease in value based upon an increase in the loss severity assumption and would generally increase in value if the loss severity assumption were to decrease.

Commercial loans

Estimated fair values for commercial mezzanine loans are determined by both market comparable pricing and discounted cash flow analysis valuation techniques (Level 3). Our discounted cash flow models utilize certain significant unobservable inputs including the underwritten net operating income and debt coverage ratio assumptions and actual performance relative to those underwritten metrics. A decrease in these unobservable inputs will reduce the estimated fair value of the commercial loans.

Estimated fair values for commercial senior mortgage loans are determined by an exit price to securitization. Certain significant inputs in the valuation analysis are Level 3 in nature. Relevant market indicators that are factored into the analyses include third-party Commercial Mortgage-Backed Securities (“CMBS”) sales, pricing points for secondary sales of CMBS, yields for synthetic instruments that use CMBS bonds as an underlying index, indexed swap yields, credit rating agency guidance on expected credit enhancement levels for newly issued CMBS transactions, and interest rates (Level 3). In certain cases, commercial senior mortgage loans are valued based on third-party offers for purchase into securitization (Level 2).

Real estate securities

Real estate securities include residential, commercial, and other asset-backed securities that are generally illiquid in nature and trade infrequently. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. 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 into 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). 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 serious delinquencies. Conversely, the estimated fair value of our securities would generally increase if the prepayment rate or credit support inputs were to increase.

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 September 30, 2013, we received dealer price indications on 78% of our securities, representing 91% of our carrying value. In the aggregate, our internal valuations of the securities for which we received dealer price indications were 1% lower than the aggregate 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 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 supported 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). Our derivative valuation models for interest rate agreements 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 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/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). At September 30, 2013 and December 31, 2012, we had no Level 3 derivatives.

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 at consolidated Sequoia entities and at the Residential Resecuritization and Commercial Securitization 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).

MSRs

MSRs include the rights to service 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. These inputs include market discount rates, prepayment speeds of serviced loans, and the market cost of servicing. 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 MSR income, which is what we believe market participants would use to estimate fair value (Level 3). These discounted cash flow models utilize certain significant unobservable inputs including prepayment rate and discount rate assumptions. An increase in these unobservable inputs will reduce the estimated fair value of the MSRs and alternatively, a decrease in these inputs will increase the estimated fair value of the MSRs. As part of our MSR valuation process, we received a valuation estimate from a third-party valuations group. In the aggregate, our internal valuation of the MSRs was less than 1% lower than the third-party valuation.

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 1).

Short-term debt

Short-term debt includes our credit facilities that mature within one year. Fair values approximate carrying values (Level 1).

ABS issued

ABS issued includes asset-backed securities issued through the Sequoia, Residential Resecuritization, and Commercial Securitization entities. These instruments are illiquid in nature and trade infrequently, if at all. For ABS issued, we utilize both market comparable pricing and 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. Relevant market indicators factored into the analyses include bid/ask spreads, external spreads, collateral credit losses, interest rates, default rates, loss severities, and collateral prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These liabilities would generally increase in value based upon a decrease in default rates and would generally decrease in value if the prepayment rate or credit support input were to decrease.

As part of our ABS issued valuation process, we also request and consider indications of value from third-party securities dealers. For purposes of pricing our ABS issued at September 30, 2013, we received dealer price indications on 41% of our ABS issued. In the aggregate, our internal valuations of the ABS issued for which we received dealer price indications were 2% higher than the aggregate 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.

Commercial borrowings

Commercial borrowings include our commercial loan repurchase agreement that matures in more than one year. Fair values approximate carrying values (Level 1).

Convertible notes

Convertible notes include unsecured convertible senior notes. Fair values are determined using quoted prices in active markets (Level 1).

Other long-term debt

Other long-term debt includes trust preferred securities and subordinated notes. Estimated fair values 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).