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Fair Value of Financial Instruments | 9 Months Ended
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Sep. 30, 2014
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 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, 2014 and December 31, 2013.
|  | September 30, 2014 |  |  | December 31, 2013 |
(In Thousands) |  | Carrying Value |  |  | Fair Value |  |  | Carrying Value |  |  | Fair Value |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, held-for-sale |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
At fair value |  | $ | 1,501,252 |  |  | $ | 1,501,252 |  |  | $ | 402,602 |  |  | $ | 402,602 |
At lower of cost or fair value |  |  | 1,502 |  |  |  | 1,662 |  |  |  | 1,665 |  |  |  | 1,817 |
Residential loans, held-for-investment, at fair value |  |  | 238,326 |  |  |  | 238,326 |  |  |  | - |  |  |  | - |
Residential loans, held-for-investment |  |  | 1,546,507 |  |  |  | 1,447,463 |  |  |  | 1,762,167 |  |  |  | 1,610,024 |
Commercial loans, held-for-sale |  |  | 175,421 |  |  |  | 175,421 |  |  |  | 89,111 |  |  |  | 89,111 |
Commercial loans, held-for-investment |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
At fair value |  |  | 70,712 |  |  |  | 70,712 |  |  |  | - |  |  |  | - |
At amortized cost |  |  | 322,576 |  |  |  | 328,076 |  |  |  | 343,344 |  |  |  | 348,305 |
Trading securities |  |  | 108,750 |  |  |  | 108,750 |  |  |  | 124,555 |  |  |  | 124,555 |
Available-for-sale securities |  |  | 1,286,235 |  |  |  | 1,286,235 |  |  |  | 1,558,306 |  |  |  | 1,558,306 |
MSRs |  |  | 135,152 |  |  |  | 135,152 |  |  |  | 64,824 |  |  |  | 64,824 |
Cash and cash equivalents |  |  | 149,617 |  |  |  | 149,617 |  |  |  | 173,201 |  |  |  | 173,201 |
Restricted cash |  |  | 455 |  |  |  | 455 |  |  |  | 398 |  |  |  | 398 |
Accrued interest receivable |  |  | 15,261 |  |  |  | 15,261 |  |  |  | 13,475 |  |  |  | 13,475 |
Derivative assets |  |  | 7,756 |  |  |  | 7,756 |  |  |  | 7,787 |  |  |  | 7,787 |
REO (1) |  |  | 3,349 |  |  |  | 3,407 |  |  |  | 3,661 |  |  |  | 4,084 |
Margin receivable (1) |  |  | 56,217 |  |  |  | 56,217 |  |  |  | 31,149 |  |  |  | 31,149 |
Other collateral posted (1) |  |  | 5,000 |  |  |  | 5,000 |  |  |  | 5,000 |  |  |  | 5,000 |
Liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Short-term debt |  | $ | 1,887,688 |  |  | $ | 1,887,688 |  |  | $ | 862,763 |  |  | $ | 862,763 |
Accrued interest payable |  |  | 10,480 |  |  |  | 10,480 |  |  |  | 6,366 |  |  |  | 6,366 |
Derivative liabilities |  |  | 38,263 |  |  |  | 38,263 |  |  |  | 18,167 |  |  |  | 18,167 |
ABS issued |  |  | 1,656,202 |  |  |  | 1,548,795 |  |  |  | 1,942,962 |  |  |  | 1,746,906 |
FHLBC Borrowings |  |  | 203,756 |  |  |  | 203,756 |  |  |  | - |  |  |  | - |
Commercial long-term debt |  |  | - |  |  |  | - |  |  |  | 49,467 |  |  |  | 49,467 |
Commercial secured borrowings |  |  | 66,146 |  |  |  | 66,146 |  |  |  | - |  |  |  | - |
Convertible notes |  |  | 287,500 |  |  |  | 285,344 |  |  |  | 287,500 |  |  |  | 299,719 |
Other long-term debt |  |  | 139,500 |  |  |  | 101,835 |  |  |  | 139,500 |  |  |  | 111,600 |
(1) | These assets are included in Other Assets on our consolidated balance sheets.
We elected the fair value option for $3.31 billion and $6.12 billion of residential loans (principal balance) and $340 million and $609 million of commercial loans (principal balance) we acquired during the three and nine months ended September 30, 2014, respectively. We also elected the fair value option for $65 million of commercial secured borrowings we recorded during the nine months ended September 30, 2014. We anticipate electing the fair value option for all future purchases of residential loans and commercial senior loans that we intend to sell to third parties or transfer to securitizations. The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis at September 30, 2014, 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, 2014
September 30, 2014 |  | Carrying |  |  | Fair Value Measurements Using |
(In Thousands) |  | Value |  |  | Level 1 |  |  | Level 2 |  |  | Level 3 |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, at fair value |  | $ | 1,739,578 |  |  | $ | - |  |  | $ | 399,145 |  |  | $ | 1,340,433 |
Commercial loans, at fair value |  |  | 175,421 |  |  |  | - |  |  |  | - |  |  |  | 175,421 |
Trading securities |  |  | 108,750 |  |  |  | - |  |  |  | - |  |  |  | 108,750 |
Available-for-sale securities |  |  | 1,286,235 |  |  |  | - |  |  |  | - |  |  |  | 1,286,235 |
MSRs |  |  | 135,152 |  |  |  | - |  |  |  | - |  |  |  | 135,152 |
Derivative assets |  |  | 7,756 |  |  |  | 1,496 |  |  |  | 5,327 |  |  |  | 933 |
Liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Derivative liabilities |  |  | 38,263 |  |  |  | 3,709 |  |  |  | 34,472 |  |  |  | 82 |
Commercial secured borrowings |  |  | 66,146 |  |  |  | - |  |  |  | - |  |  |  | 66,146 |
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, 2014. Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
|  | Assets |  |  |  |  |  | Liabilities |
(In Thousands) |  | Residential Loans |  |  | Commercial Loans |  |  | Trading Securities |  |  | AFS Securities |  |  | MSRs |  |  | Derivatives (1) |  |  | Commercial Secured Borrowings |
Beginning balance - December 31, 2013 |  | $ | 391,100 |  |  | $ | 89,111 |  |  | $ | 124,555 |  |  | $ | 1,558,306 |  |  | $ | 64,824 |  |  | $ | (379) |  |  | $ | - |
Principal paydowns |  |  | (20,728) |  |  |  | (3,684) |  |  |  | (5,848) |  |  |  | (138,751) |  |  |  | - |  |  |  | - |  |  |  | (1,081) |
Discount accretion |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 32,774 |  |  |  | - |  |  |  | - |  |  |  | - |
Gains (losses) in net income, net |  |  | 35,971 |  |  |  | 14,986 |  |  |  | (15,041) |  |  |  | 9,389 |  |  |  | (5,944) |  |  |  | 6,434 |  |  |  | 2,179 |
Unrealized gains in OCI, net |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 28,328 |  |  |  | - |  |  |  | - |  |  |  | - |
Acquisitions |  |  | 3,557,753 |  |  |  | 611,624 |  |  |  | 66,253 |  |  |  | 192,151 |  |  |  | 76,272 |  |  |  | - |  |  |  | 65,048 |
Sales |  |  | (2,621,349) |  |  |  | (536,671) |  |  |  | (61,169) |  |  |  | (395,962) |  |  |  | - |  |  |  | - |  |  |  | - |
Other settlements, net |  |  | (2,314) |  |  |  | 55 |  |  |  | - |  |  |  | - |  |  |  | - |  |  |  | (5,204) |  |  |  | - |
Ending balance - September 30, 2014 |  | $ | 1,340,433 |  |  | $ | 175,421 |  |  | $ | 108,750 |  |  | $ | 1,286,235 |  |  | $ | 135,152 |  |  | $ | 851 |  |  | $ | 66,146 |
(1) For the purpose of this presentation, derivative assets and liabilities, which consist of loan purchase commitments, are presented net. 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, 2014 and 2013. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and nine months ended September 30, 2014 and 2013 are not included in this presentation. Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at September 30, 2014 and 2013 Included in Net Income
|  | Included in Net Income |
|  | Three Months Ended September 30, |  |  | Nine Months Ended September 30, |
(In Thousands) |  | 2014 |  |  | 2013 |  |  | 2014 |  |  | 2013 |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, at fair value |  | $ | 7,280 |  |  | $ | (1,864) |  |  | $ | 8,524 |  |  | $ | (3,088) |
Commercial loans, at fair value |  |  | 2,009 |  |  |  | 831 |  |  |  | 2,009 |  |  |  | 831 |
Trading securities |  |  | (1,882) |  |  |  | (1,525) |  |  |  | (16,033) |  |  |  | 28,491 |
Available-for-sale securities |  |  | (188) |  |  |  | - |  |  |  | (434) |  |  |  | 940 |
MSRs |  |  | 3,509 |  |  |  | 1,344 |  |  |  | (3,184) |  |  |  | 12,561 |
Liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Loan purchase commitments |  |  | 932 |  |  |  | - |  |  |  | 932 |  |  |  | - |
Commercial secured borrowing |  |  | (420) |  |  |  | - |  |  |  | 1,339 |  |  |  | - |
The following table presents information on assets recorded at fair value on a non-recurring basis at September 30, 2014. 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, 2014. Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at September 30, 2014
|  |  |  |  |  |  |  | Gain (Loss) for |
September 30, 2014 |  | Carrying |  |  | Fair Value Measurements Using |  |  | Three Months Ended |  |  | Nine Months Ended |
(In Thousands) |  | Value |  |  | Level 1 |  |  | Level 2 |  |  | Level 3 |  |  | September 30, 2014 |  |  | September 30, 2014 |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, at lower of cost or fair value |  | $ | 1,106 |  |  | $ | - |  |  | $ | - |  |  | $ | 1,106 |  |  | $ | 1 |  |  | $ | (1) |
REO |  |  | 1,944 |  |  |  | - |  |  |  | - |  |  |  | 1,994 |  |  |  | 0 |  |  |  | (133) |
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, 2014 and 2013. Market Valuation Adjustments, Net
|  | Three Months Ended September 30, |  |  | Nine Months Ended September 30, |
(In Thousands) |  | 2014 |  |  | 2013 |  |  | 2014 |  |  | 2013 |
Mortgage banking activities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, at fair value |  | $ | 13,446 |  |  | $ | (10,804) |  |  | $ | 34,554 |  |  | $ | (17,339) |
Commercial loans, at fair value |  |  | 4,305 |  |  |  | 3,171 |  |  |  | 13,644 |  |  |  | 2,826 |
Trading securities |  |  | (1,332) |  |  |  | (1,866) |  |  |  | (14,419) |  |  |  | 36,399 |
Derivative instruments, net |  |  | (2,404) |  |  |  | 442 |  |  |  | (18,159) |  |  |  | 51,009 |
Loan purchase and forward sale commitments |  |  | 2,487 |  |  |  | - |  |  |  | 6,077 |  |  |  | - |
Total mortgage banking activites (1) |  |  | 16,502 |  |  |  | (9,057) |  |  |  | 21,697 |  |  |  | 72,895 |
MSRs |  |  | 2,321 |  |  |  | 460 |  |  |  | (5,944) |  |  |  | 9,628 |
Other |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, at lower of cost or fair value |  |  | 43 |  |  |  | (11) |  |  |  | 54 |  |  |  | 68 |
Held-for-investment loans at fair value |  |  | (991) |  |  |  | - |  |  |  | (991) |  |  |  | - |
Trading securities |  |  | (577) |  |  |  | 540 |  |  |  | (653) |  |  |  | (4,168) |
Impairments on AFS securities |  |  | (188) |  |  |  | - |  |  |  | (565) |  |  |  | (1,666) |
REO |  |  | (361) |  |  |  | (76) |  |  |  | (825) |  |  |  | (407) |
Other derivative instruments, net |  |  | (1,632) |  |  |  | 9 |  |  |  | (10,986) |  |  |  | 74 |
Total other |  |  | (3,706) |  |  |  | 462 |  |  |  | (13,966) |  |  |  | (6,099) |
Total Market Valuation Adjustments, Net |  | $ | 15,117 |  |  | $ | (8,135) |  |  | $ | 1,787 |  |  | $ | 76,425 |
(1) | Income from mortgage banking activities presented above does not include fee income or provisions for repurchases that is a component of mortgage banking income presented on our consolidated statements of income as these amounts do not represent a market valuation adjustment.
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 group using the valuation processes 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 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, 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, 2014 (Dollars in Thousands) |  | Fair Value |  |  | Unobservable Input |  | Range |  |  | Weighted Average |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential loans, at fair value: |  |  |  |  |  |  |  |  |  |  |  |  |  |
Loans priced to securitization or priced to whole loan market and uncommitted to sell |  | $ | 758,501 |  |  | Discount rate |  |  | 4 - 5 % |  |  |  | 4 % |
|  |  |  |  |  | Prepayment rate |  |  | 8 - 8 % |  |  |  | 8 % |
|  |  |  |  |  | Default rate |  |  | 1 - 1 % |  |  |  | 1 % |
|  |  |  |  |  | Loss severity |  |  | 20 - 20 % |  |  |  | 20 % |
|  |  |  |  |  | Credit support |  |  | 8 - 8 % |  |  |  | 8 % |
|  |  |  |  |  | Spread to securitization |  |  | 38 - 38 bps |  |  |  | 38 bps |
|  |  |  |  |  | Credit spread |  |  | 118 - 173 bps |  |  |  | 129 bps |
Loans priced to whole loan market, committed to sell |  |  | 581,932 |  |  | Pool fallout assumption |  |  | 10 bps - 10 bps |  |  |  | 10 bps |
Residential loans, at lower of cost or fair value |  |  | 1,106 |  |  | Loss severity |  |  | 15-28 % |  |  |  | 21 % |
Commercial loans, at fair value |  |  | 175,421 |  |  | Credit spread |  |  | 152 bps - 152 bps |  |  |  | 152 bps |
|  |  |  |  |  | Credit support |  |  | 24 - 24 % |  |  |  | 24 % |
Trading and AFS securities |  |  | 1,394,985 |  |  | Discount rate |  |  | 4 - 12 % |  |  |  | 6 % |
|  |  |  |  |  | Prepayment speed |  |  | 1 - 35 % |  |  |  | 12 % |
|  |  |  |  |  | Default rate |  |  | 0 - 35 % |  |  |  | 8 % |
|  |  |  |  |  | Loss severity |  |  | 20 - 64 % |  |  |  | 35 % |
|  |  |  |  |  | Credit support |  |  | 0 - 88 % |  |  |  | 6 % |
MSRs |  |  | 135,152 |  |  | Discount rate |  |  | 8 - 11 % |  |  |  | 10 % |
|  |  |  |  |  | Prepayment rate |  |  | 4 - 60 % |  |  |  | 10 % |
REO |  |  | 1,994 |  |  | Loss severity |  |  | 13 - 96 % |  |  |  | 34 % |
Loan purchase commitments, net (1) |  |  | 851 |  |  | MSR Multiple |  |  | 1 - 5x |  |  |  | 4x |
|  |  |  |  |  | Pullthrough rate |  |  | 58 - 99 % |  |  |  | 82 % |
Liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |
Commercial secured financing |  |  | 66,146 |  |  | Credit spread |  |  | 152 bps - 152 bps |  |  |  | 152 bps |
|  |  |  |  |  | Credit support |  |  | 24 - 24 % |  |  |  | 24 % |
(1) 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 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 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. Estimated fair values for conforming loans are determined based upon quoted market prices (Level 2). Conforming loans are mortgage loans that conform to Agency guidelines. As necessary, these values are adjusted for servicing value, market conditions and liquidity. Commercial loans Estimated fair values for senior commercial 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 the securities for purchase into securitization (Level 2). Estimated fair values for mezzanine commercial 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 as well as estimated market discount rates. A decrease in these unobservable inputs will reduce the estimated fair value of the commercial loans. Real estate securities Real estate securities primarily include residential mortgage-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 analyses include bid/ask spreads, the amount and timing of 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 or loss severities, or a decrease in prepayment speeds 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 September 30, 2014, we received dealer price indications on 81% of our securities, representing 94% of our carrying value. In the aggregate, our internal valuations of the securities for which we received dealer price indications were within 2% of 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 swaps, swaptions, TBAs, financial futures, CMBX credit default index swaps, LPCs, and FSCs. 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. TBA and financial futures fair values 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). CMBX credit default index swaps are generally obtained using quoted prices; however, they are not always actively traded (Level 2). LPC fair values are estimated based on quoted Agency MBS prices, estimates of the fair value of the MSRs we expect to retain in the sale of the loans, and the probability that the mortgage loan will be purchased (Level 3). FSC fair values are obtained using quoted Agency prices. Model inputs 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). MSRs MSRs represent 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. 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. 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 at September 30, 2014. 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). 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, 2014, we received dealer price indications on 42% of our ABS issued. In the aggregate, our internal valuations of the ABS issued for which we received dealer price indications were within 1% of 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. FHLBC Borrowings FHLBC borrowings include amounts borrowed from the Federal Home Loan Bank of Chicago that are secured by residential mortgage loans or residential mortgage-backed securities. 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 1). Commercial secured borrowings Commercial secured borrowings represent liabilities recognized as a result of transfers of portions of senior commercial mortgage loans to third parties that do not meet the criteria for sale treatment under GAAP and are accounted for as secured borrowings. Fair values for commercial secured borrowings are based on the fair values of the senior commercial loans associated with the borrowings (Level 3). Convertible notes Convertible notes include unsecured convertible senior notes. Fair values are determined using quoted prices in active markets (Level 1). 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).

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- 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. + References Reference 1: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 21 -URI http://asc.fasb.org/extlink&oid=35750535&loc=d3e13537-108611 Reference 2: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 10 -URI http://asc.fasb.org/extlink&oid=35750535&loc=d3e13433-108611 Reference 3: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 28 -URI http://asc.fasb.org/extlink&oid=6957238&loc=d3e14064-108612 Reference 4: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 820 -SubTopic 10 -Section 50 -Paragraph 2 -URI http://asc.fasb.org/extlink&oid=36462937&loc=d3e19207-110258 Reference 5: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 30 -URI http://asc.fasb.org/extlink&oid=6957238&loc=d3e14172-108612 Reference 6: http://www.xbrl.org/2003/role/presentationRef -Publisher FASB -Name Accounting Standards Codification -Topic 825 -SubTopic 10 -Section 50 -Paragraph 16 -URI http://asc.fasb.org/extlink&oid=35750535&loc=d3e13504-108611 + Details
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