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 December 31, 2014 and 2013.


	December 31, 2014				December 31, 2013
(In Thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Residential loans, held-for-sale
At fair value	$	1,341,032	$	1,341,032	$	402,602	$	402,602
At lower of cost or fair value		1,488		1,669		1,665		1,817
Residential loans, held-for-investment, at fair value		581,668		581,668		—		—
Residential loans, held-for-investment		1,474,386		1,381,918		1,762,167		1,610,024
Commercial loans, held-for-sale, at fair value		166,234		166,234		89,111		89,111
Commercial loans, held-for-investment
At fair value		71,262		71,262		—		—
At amortized cost		329,431		334,876		343,344		348,305
Trading securities		111,606		111,606		124,555		124,555
Available-for-sale securities		1,267,624		1,267,624		1,558,306		1,558,306
MSRs		139,293		139,293		64,824		64,824
Cash and cash equivalents		269,730		269,730		173,201		173,201
Restricted cash		628		628		398		398
Accrued interest receivable		18,222		18,222		13,475		13,475
Derivative assets		16,417		16,417		7,787		7,787
REO ⁽¹⁾		4,391		4,703		3,661		4,084
Margin receivable ⁽¹⁾		65,374		65,374		31,149		31,149
FHLBC stock ⁽¹⁾		10,688		10,688		—		—
Guarantee asset ⁽¹⁾		7,201		7,201		—		—
Pledged collateral ⁽¹⁾		9,927		9,927		—		—
Liabilities
Short-term debt	$	1,793,825	$	1,793,825	$	862,763	$	862,763
Accrued interest payable		8,502		8,502		6,366		6,366
Guarantee obligation		7,201		7,201		—		—
Derivative liabilities		58,331		58,331		18,167		18,167
ABS issued		1,545,119		1,446,605		1,942,962		1,746,906
FHLBC Borrowings		495,860		495,860		—		—
Commercial long-term debt		—		—		49,467		49,467
Commercial secured borrowings		66,707		66,707		—		—
Convertible notes		492,500		492,188		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.

During the year ended December 31, 2014, we elected the fair value option for $77 million of residential senior securities, $9 million of residential subordinate securities, $8.81 billion of residential loans (principal balance), $935 million of commercial senior loans (principal balance), $96 million of MSRs, and $7 million of guarantee assets. During the year ended December 31, 2013, we elected the fair value option for $105 million of residential senior securities, $4 million of residential subordinate securities, $7.09 billion of residential loans (principal balance), $505 million of commercial senior loans (principal balance), and $48 million of MSRs. 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 as well as for MSRs purchased or retained from sales of residential loans.

The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis as well as their classification in the fair value hierarchy based on the valuation inputs used to measure their fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis


December 31, 2014 (In Thousands)	Carrying Value		Fair Value Measurements Using
December 31, 2014 (In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans, at fair value	$	1,922,700	$	—	$	244,716	$	1,677,984
Commercial loans, at fair value		237,496		—		—		237,496
Trading securities		111,606		—		—		111,606
Available-for-sale securities		1,267,624		—		—		1,267,624
Derivative assets		16,417		6,654		8,603		1,160
MSRs		139,293		—		—		139,293
Pledged collateral		9,927		9,927		—		—
FHLBC Stock		10,688		10,688		—		—
Guarantee asset		7,201		—		—		7,201
Liabilities
Derivative liabilities		58,331		9,878		48,412		41
Commercial secured borrowings		66,707		—		—		66,707

December 31, 2013 (In Thousands)	Carrying Value		Fair Value Measurements Using
December 31, 2013 (In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans, at fair value	$	402,602	$	—	$	11,502	$	391,100
Commercial loans, at fair value		89,111		—		—		89,111
Trading securities		124,555		—		—		124,555
Available-for-sale securities		1,558,306		—		—		1,558,306
MSRs		64,824		—		—		64,824
Derivative assets		7,787		1,139		6,648		—
Liabilities
Derivative liabilities		18,167		1,189		16,599		379

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the years ended December 31, 2014 and 2013.

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			Guarantee Asset		Loan Purchase Commitments⁽¹⁾			Commercial Secured Borrowings
Beginning balance - December 31, 2013	$	391,100		$	89,111		$	124,555		$	1,558,306		$	64,824		$	—	$	(379	)	$	—
Principal paydowns		(42,657	)		(4,157	)		(5,934	)		(168,308	)		—			—		—			(374	)
Amortization income		—			—			—			32,774			—			—		—			—
Gains (losses) in net income, net		56,835			22,824			(24,167	)		23,412			(21,081	)		—		14,527			2,033
Unrealized gains in OCI, net		—			—			—			24,302			—			—		—			—
Acquisitions		5,020,988			937,594			81,545			237,499			95,550			7,201		—			65,048
Sales		(3,746,417	)		(807,931	)		(64,393	)		(440,361	)		—			—		—			—
Other settlements, net		(1,865	)		55			—			—			—			—		(13,029	)		—

Ending balance - December 31, 2014	$	1,677,984		$	237,496		$	111,606		$	1,267,624		$	139,293		$	7,201	$	1,119		$	66,707


	Assets														Liabilities
(In Thousands)	Residential Loans			Commercial Loans			Trading Securities			AFS Securities			MSRs		Loan Purchase Commitments⁽¹⁾
Beginning balance - December 31, 2012	$	553,576		$	—		$	33,172		$	1,075,581		$	5,315	$	—
Principal paydowns		(16,166	)		(189	)		(1,244	)		(162,708	)		—		—
(Losses) gains in net income, net		(34,650	)		8,694			41,074			57,852			11,995		480
Unrealized losses in OCI, net		—			—			—			(21,924	)		—		—
Acquisitions		7,090,724			505,151			109,320			785,671			47,514		—
Sales		(7,201,472	)		(424,545	)		(57,767	)		(176,166	)		—		—
Other settlements, net		(912	)		—			—			—			—		(101	)

Ending balance - December 31, 2013	$	391,100		$	89,111		$	124,555		$	1,558,306		$	64,824	$	379

(1)	Loan Purchase Commitments are presented net, and may have an asset or liability beginning or ending balance.

The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and held at December 31, 2014, 2013, and 2012. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the years ended December 31, 2014, 2013, and 2012 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at December 31, 2014, 2013, and 2012 Included in Net Income


	Included in Net Income Years Ended December 31,
(In Thousands)	2014			2013			2012
Assets
Residential loans, at fair value	$	16,512		$	(290	)	$	11,725
Commercial loans, at fair value		3,357			1,501			—
Trading securities		(25,216	)		32,496			(14,076	)
Available-for-sale securities		(434	)		(1,108	)		(2,509	)
MSRs		(15,239	)		14,196			(1,571	)
Loan purchase commitments		1,119			—			—
Liabilities
Loan purchase commitments		—			(379	)		—
Commercial secured borrowing		2,033			—			—

The following table presents information on assets recorded at fair value on a non-recurring basis at December 31, 2014 and 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 December 31, 2014 and 2013.

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


December 31, 2014 (In Thousands)	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended December 31, 2014
December 31, 2014 (In Thousands)	Carrying Value		Level 1		Level 2		Level 3		Gain (Loss) for Year Ended December 31, 2014
Assets
Residential loans, at lower of cost or fair value	$	1,104	$	—	$	—	$	1,104	$	(1	)
REO		2,069		—		—		2,069		(320	)
Liabilities
Guarantee obligation		7,201		—		—		7,201		—


December 31, 2013 (In Thousands)	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended December 31, 2013
December 31, 2013 (In Thousands)	Carrying Value		Level 1		Level 2		Level 3		Gain (Loss) for Year Ended December 31, 2013
Assets
Residential loans, at lower of cost or fair value	$	1,145	$	—	$	—	$	1,145	$	—
REO		1,518		—		—		1,518		(270	)

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the years ended December 31, 2014, 2013, and 2012.

Market Valuation Adjustments


	Years Ended December 31,
(In Thousands)	2014			2013			2012
Mortgage banking activities
Residential loans, at fair value	$	51,256		$	(10,493	)	$	37,762
Commercial loans, at fair value		20,788			8,694			—
Sequoia IO securities		(23,839	)		42,451			(11,702	)
Risk management derivatives, net		(31,167	)		51,162			(10,609	)
Loan purchase and forward sale commitments		13,891			(399	)		—

Total mortgage banking activities⁽¹⁾		30,929			91,415			15,451

MSRs		(21,081	)		11,995			(2,014	)
Other
Residential loans, at lower of cost or fair value	$	56		$	38		$	623
Commercial loans, at fair value		—			—			241
Residential loans held-for-investment, at fair value		(697	)		—			—
Trading securities		(358	)		(3,525	)		97,867
Impairments on AFS securities		(565	)		(1,833	)		(2,509	)
REO		(894	)		(612	)		(344	)
Other derivative instruments, net		(7,792	)		223			(12,581	)
ABS issued - Acacia		—			—			(81,758	)
Other		104			—			—

Total other		(10,146	)		(5,709	)		1,539

Total Market Valuation Adjustments, Net	$	(298	)	$	97,701		$	14,976

(1)	Income from mortgage banking activities presented above does not include fee income or provisions for repurchases that is a component of mortgage banking activities 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


December 31, 2014 (Dollars in Thousands)	Fair Value		Unobservable Input	Range	Weighted Average
Assets
Residential loans, at fair value:
Jumbo fixed rate loans priced to securitization or to whole loan market and uncommitted to sell	$	1,231,823	IO discount rate	5 - 8%		7	%
			Prepayment rate	10 - 12%		11	%
			Senior credit spread	300 - 300 bps		300	bps
			Subordinate credit spread	326 - 326 bps		326	bps
			Credit support	8 - 8%		8	%
			Whole loan credit spread	290 - 425 bps		411	bps
Jumbo hybrid loans priced to whole loan market and uncommitted to sell		150,065	Prepayment rate	15 - 15%		15	%
			Credit spread	120 - 170 bps		127	bps
Jumbo loans priced to whole loan market and committed to sell		296,096	Committed Sales Price	$102 - 103	$	103
Residential loans, held-for-sale		1,104	Loss severity	13 - 30%		20	%
Commercial loans, at fair value		237,496	Credit spread	157 - 163 bps		161	bps
			Credit support	23 - 25%		24	%
Trading and AFS securities		1,379,230	Discount rate	4 - 12%		6	%
			Prepayment speed	1 - 35%		12	%
			Default rate	0 - 35%		8	%
			Loss severity	20 - 64%		34	%
			Credit support	0 - 48%		5	%
Guarantee asset		7,201	Discount rate	11 - 11%		11	%
			Prepayment speed	5 - 27%		11	%
MSRs		139,293	Discount rate	8 - 11%		10	%
			Prepayment rate	4 - 60%		12	%
			Per loan annual cost to service	$72 - 82	$	77
REO		2,069	Loss severity	0 - 100%		39	%
Loan purchase commitments, net ⁽¹⁾		1,119	MSR Multiple	0 - 6x		4x
			Pullthrough rate	56 - 99%		83	%
Liabilities
Commercial secured financing		66,707	Credit spread	161 - 161 bps		161	bps
			Credit support	23 - 23%		23	%

(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 RMBS and related inputs. Relevant market indicators that are factored into the analyses include third-party RMBS sales and pricing points for secondary sales of RMBS we have issued in past periods (which both provide indicative credit spreads), as well as Agency RMBS, indexed swap yields, credit rating agency guidance on expected credit support levels for newly issued RMBS transactions, interest rates, and prepayment speeds (Level 3). These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed or credit support assumptions.

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 (which provide indicative credit spreads), indexed swap yields, interest rates, and prepayment speeds (Level 3). These assets would generally decrease in value based upon an increase in the credit spread assumption.

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 held-for-sale 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 pricing points for current 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). The estimated fair value of our senior commercial loans would generally decrease based upon an increase in credit spreads or required credit support.

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. An increase in market discount rates would reduce the estimated fair value of the commercial loans.

Real estate securities

Real estate securities include residential, commercial, and other asset-backed securities that are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators that are factored into the 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 December 31, 2014, we received dealer price indications on 86% of our securities, representing 97% of our carrying value. In the aggregate, our internal valuations of the securities for which we received dealer price indications were 2% lower than the aggregate average dealer valuations. Once we receive the price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are required to estimate fair value.

Derivative assets and liabilities

Our derivative instruments include swaps, swaptions, TBAs, financial futures, 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). 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 include the rights to service jumbo and conforming residential mortgage loans. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. 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 future 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 firm. In the aggregate, our internal valuation of the MSRs was less than 2% lower than the third-party valuation.

FHLBC Stock

Our FHLBC member subsidiary is required to purchase FHLBC stock under a borrowing agreement between our FHLBC member subsidiary and the FHLBC. Under this agreement, the stock is redeemable at face value, which represents the carrying value and fair value of the stock (Level 1).

Guarantee Asset

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

Pledged Collateral

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

Cash and cash equivalents

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

Restricted cash

Restricted cash primarily includes interest-earning cash balances 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. 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).

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 or loss severity and would generally decrease in value if the prepayment rate or level of credit support 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 December 31, 2014, we received dealer price indications on 44% of our ABS issued. In the aggregate, our internal valuations of the ABS issued for which we received dealer price indications were 1% 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.

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 and exchangeable 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).