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 March 31, 2015 and December 31, 2014.



	March 31, 2015				December 31, 2014
	Carrying Value		Fair Value		Carrying Value		Fair Value
(In Thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Residential loans, held-for-sale
At fair value	$	1,093,413	$	1,093,413	$	1,341,032	$	1,341,032
At lower of cost or fair value	1,472		1,663		1,488		1,669
Residential loans, held-for-investment ⁽¹⁾
At fair value	2,304,870		2,304,870		581,668		581,668
At amortized cost	—		—		1,474,386		1,381,918
Commercial loans, held-for-sale	54,407		54,407		166,234		166,234
Commercial loans, held-for-investment
At fair value	72,619		72,619		71,262		71,262
At amortized cost	333,316		338,932		329,431		334,876
Trading securities	106,837		106,837		111,606		111,606
Available-for-sale securities	1,178,406		1,178,406		1,267,624		1,267,624
MSRs	120,324		120,324		139,293		139,293
Cash and cash equivalents	303,820		303,820		269,730		269,730
Restricted cash	725		725		628		628
Accrued interest receivable	17,970		17,970		18,222		18,222
Derivative assets	30,546		30,546		16,417		16,417
REO ⁽²⁾	5,305		5,446		4,391		4,703
Margin receivable⁽²⁾	79,760		79,760		65,374		65,374
FHLBC stock ⁽²⁾	28,434		28,434		10,688		10,688
Guarantee asset⁽²⁾	6,118		6,118		7,201		7,201
Pledged collateral⁽²⁾	10,265		10,265		9,927		9,927

Liabilities
Short-term debt	$	1,502,164	$	1,502,164	$	1,793,825	$	1,793,825
Accrued interest payable	14,319		14,319		8,502		8,502
Guarantee obligation	6,917		6,917		7,201		7,201
Derivative liabilities	68,064		68,064		58,331		58,331
ABS issued⁽¹⁾
Fair value	1,239,065		1,239,065		—		—
Amortized cost	113,956		114,613		1,545,119		1,446,605
FHLBC borrowings	850,792		850,792		495,860		495,860
Commercial secured borrowings	68,077		68,077		66,707		66,707
Convertible notes	492,500		488,243		492,500		492,188
Other long-term debt	139,500		97,650		139,500		101,835


(1)	Upon adoption of ASU 2014-13 on January 1, 2015, loans held-for-investment and ABS issued by consolidated Sequoia entities began to be recorded at fair value. See Note 3 for further discussion.


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

During the three months ended March 31, 2015, we elected the fair value option for $23 million of residential subordinate securities, $2.40 billion of residential loans (principal balance), $93 million of commercial loans (principal balance), and $19 million of MSRs, respectively. 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 at March 31, 2015, 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 March 31, 2015



March 31, 2015	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	3,398,283	$	—	$	200,869	$	3,197,414
Commercial loans	127,026		—		—		127,026
Trading securities	106,837		—		—		106,837
Available-for-sale securities	1,178,406		—		—		1,178,406
Derivative assets	30,546		4,721		17,554		8,271
MSRs	120,324		—		—		120,324
Pledged collateral	10,265		10,265		—		—
FHLBC stock	28,434		28,434		—		—
Guarantee asset	6,118		—		—		6,118

Liabilities
Derivative liabilities	68,064		9,173		58,045		846
Commercial secured borrowings	68,077		—		—		68,077
ABS issued	1,239,065		—		—		1,239,065

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the three months ended March 31, 2015.

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



	Assets																					Liabilities
	Residential Loans			Commercial Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives⁽¹⁾			Commercial Secured Borrowings			ABS Issued
(In Thousands)	Residential Loans			Commercial Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives⁽¹⁾			Commercial Secured Borrowings			ABS Issued
Beginning balance - December 31, 2014	$	1,677,984		$	237,496		$	111,606		$	1,267,624		$	139,293		$	7,201		$	1,119		$	66,707		$	—
Transfer to FVO ⁽²⁾	1,370,699			—			—			—			—			—			—			—			1,302,216
Principal paydowns	(111,716		)	(240		)	(203		)	(26,110		)	—			—			—			(152		)	(66,517		)
Amortization income	—			—			—			9,838			—			—			—			—			—
Gains (losses) in net income, net	7,570			7,366			(14,114		)	4,306			(19,517		)	(1,083		)	20,087			1,509			2,946
Unrealized gains in OCI, net	—			—			—			3,795			—			—			—			—			—
Acquisitions	1,112,042			92,713			23,084			9,831			18,754			—			—			—			—
Sales	(857,249		)	(210,309		)	(13,536		)	(90,878		)	(18,206		)	—			—			—			—
Other settlements, net	(1,916		)	—			—			—			—			—			(13,781		)	13			421
Ending balance - March 31, 2015	$	3,197,414		$	127,026		$	106,837		$	1,178,406		$	120,324		$	6,118		$	7,425		$	68,077		$	1,239,066

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

(2) Upon adoption of ASU 2014-13 on January 1, 2015, loans held-for-investment in, and ABS issued by, consolidated financial entities are now recorded at fair value. See Note 3 for further discussion.

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 March 31, 2015 and 2014. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three months ended March 31, 2015 and 2014 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at March 31, 2015 and 2014 Included in Net Income



	Included in Net Income
	Three Months Ended March 31,
(In Thousands)	2015			2014
Assets
Residential loans at Redwood	$	5,464		$	3,483
Residential loans at consolidated Sequoia entities	1,179			—
Commercial loans	2,959			2,530
Trading securities	(13,790		)	(4,431		)
Available-for-sale securities	—			(113		)
MSRs	(11,769		)	(2,291		)
Loan purchase commitments	7,422			—
Other assets - Guarantee asset	(1,083		)	—

Liabilities
Loan purchase commitments	—			(235		)
Commercial secured borrowing	(1,509		)	—
ABS issued	(2,946		)	—

The following table presents information on assets recorded at fair value on a non-recurring basis at March 31, 2015. 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 March 31, 2015.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at March 31, 2015



									Gain (Loss) for
March 31, 2015	Carrying Value		Fair Value Measurements Using						Three Months Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		March 31, 2015
Assets
Residential loans, at lower of cost or fair value	$	1,103	$	—	$	—	$	1,103	$	—
REO	3,410		—		—		3,410		(74		)

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the three months ended March 31, 2015 and 2014.

Market Valuation Adjustments, Net



	Three Months Ended March 31,
(In Thousands)	2015			2014
Mortgage banking activities
Residential loans, at fair value	$	2,056		$	7,128
Commercial loans, at fair value	5,857			3,626
Sequoia IO securities	(14,359		)	(4,277		)
Risk management derivatives, net	(10,583		)	(7,082		)
Loan purchase and forward sale commitments	18,256			8
Total mortgage banking activities⁽¹⁾	1,227			(597		)

MSRs	(19,517		)	(2,711		)
Other
Residential loans, at lower of cost or fair value	$	2		$	(2	)
Consolidated Sequoia entities ⁽²⁾	(1,093		)	—
Residential loans held-for-investment, at Redwood	1,978			—
Trading securities	270			(154		)
Impairments on AFS securities	—			(113		)
Other risk management derivative instruments, net	(1,374		)	(5,727		)
Guarantee asset	(1,083		)	—
Other	155			(142		)
Total other	(1,145		)	(6,138		)
Total Market Valuation Adjustments, Net	$	(19,435	)	$	(9,446	)


(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.

(2)

On January 1, 2015, we adopted ASU 2014-13 and began to record the assets and liabilities of consolidated Sequoia entities at fair value. This amount represents the net change in fair value of the consolidated assets and liabilities of these entities, which include residential loans held-for-investment, REO, and ABS issued. This amount also represents the estimated change in value of our retained interests in these entities. See Note 3 for further discussion.

At March 31, 2015, our valuation policy and process had not changed from those described in our Annual Report on Form 10-K. 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



March 31, 2015	Fair Value					Weighted Average
(Dollars in Thousands, except input values)	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	$	1,334,594	IO Multiple	4.0 - 4.6	x	4.2		x
			Prepayment rate (Annual CPR)	12 - 15	%	14		%
			Senior spread to TBA price	$3.13 - 3.13		$	3.13
			Subordinate spread to swap rate	315 - 315	bps	315		bps
			Credit support	8 - 8	%	8		%
			Whole loan spread to TBA price	$3.10 - 4.50		$	4.35

Jumbo hybrid loans priced to whole loan market and uncommitted to sell	137,168		Prepayment rate (Annual CPR)	15 - 15	%	15		%
			Spread to swap rate	125 - 165	bps	134		bps

Jumbo loans priced to whole loan market and committed to sell	421,226		Committed Sales Price	$102 - 103		$	103


Loans held by consolidated Sequoia entities ⁽¹⁾	1,304,426		Liability price	N/A		N/A

Residential loans, at lower of cost or fair value	1,103		Loss severity	13 - 30	%	20		%

Commercial loans, at fair value	127,026		Spread to swap rate	147 - 156	bps	154		bps
			Credit support	22 - 23	%	23		%

Trading and AFS securities	1,285,243		Discount rate	4 - 12	%	6		%
			Prepayment rate (Annual CPR)	1 - 35	%	12		%
			Default rate	0 - 35	%	8		%
			Loss severity	20 - 64	%	34		%
			Credit support	0 - 48	%	10		%

MSRs	120,324		Discount rate	9 - 11	%	10		%
			Prepayment rate (Annual CPR)	4 - 60	%	14		%
			Per loan annual cost to service	$ 72 - 82		$	77

Guarantee asset	6,118		Discount rate	11 - 11	%	11		%
			Prepayment rate (Annual CPR)	5 - 27	%	12		%

REO	3,410		Loss severity	31 - 66	%	46		%

Loan purchase commitments, net ⁽²⁾	7,425		MSR Multiple	0.0 - 5.7	x	3.5		x
			Fallout rate	2 - 98	%	33		%

Liabilities
ABS issued by consolidated Sequoia entities ⁽¹⁾	1,239,065		Discount rate	4 -8	%	5		%
			Prepayment rate (Annual CPR)	0 - 31	%	13		%
			Default rate	0 - 12	%	6		%
			Loss severity	20 - 32	%	26		%
			Credit support	0 - 65	%	11		%

Commercial secured financing	68,077		Spread to swap rate	156 - 156	bps	156		bps
			Credit support	23 - 23	%	23		%

(1) Upon adoption of ASU 2014-13 on January 1, 2015, loans held-for-investment in, and ABS issued by, consolidated Sequoia entities began to be recorded at fair value. In accordance with this new guidance, the fair value of the loans in these entities were based on the fair value of the liabilities issued by these entities, which we determined were more readily observable. See Note 3 for further discussion.

(2) 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 rates, 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 spreads to indexed TBA prices for senior securities and indexed swap rates for subordinate securities), 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 rates (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 and third-party whole loan sales (which provide indicative spreads to indexed swap rates), indexed swap yields, interest rates, and prepayment rates (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 rates. 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 rates 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 March 31, 2015, we received dealer price indications on 81% of our securities, representing 93% 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 rates 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 Federal Home Loan Bank (FHLB) member subsidiary is required to purchase Federal Home Loan Bank of Chicago (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 rates 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 generally illiquid in nature and trade infrequently. 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, the amount and timing of collateral credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These liabilities would generally decrease in value (become a larger liability) if credit losses decreased or if the prepayment rate or discount rate were to increase.

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 March 31, 2015, we received dealer price indications on 36% 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 FHLBC that are secured by residential mortgage loans. 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 2).

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).