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, 2015 and December 31, 2014.

Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities



	December 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	$	1,114,305	$	1,114,305	$	1,341,032	$	1,341,032
At lower of cost or fair value	1,433		1,635		1,488		1,669
Residential loans, held-for-investment ⁽¹⁾
At fair value	2,813,065		2,813,065		581,668		581,668
At amortized cost	—		—		1,474,386		1,381,918
Commercial loans, held-for-sale	39,141		39,141		166,234		166,234
Commercial loans, held-for-investment
At fair value	67,657		67,657		71,262		71,262
At amortized cost	295,849		300,824		329,431		334,876
Trading securities	404,011		404,011		111,606		111,606
Available-for-sale securities	829,245		829,245		1,267,624		1,267,624
MSRs	191,976		191,976		139,293		139,293
Cash and cash equivalents	220,229		220,229		269,730		269,730
Restricted cash	5,567		5,567		628		628
Accrued interest receivable	23,290		23,290		18,222		18,222
Derivative assets	16,393		16,393		16,417		16,417
REO ⁽²⁾	4,896		5,282		4,391		4,703
Margin receivable⁽²⁾	83,191		83,191		65,374		65,374
FHLBC stock ⁽²⁾	34,437		34,437		10,688		10,688
Guarantee asset⁽²⁾	5,697		5,697		7,201		7,201
Pledged collateral⁽²⁾	53,600		53,600		9,927		9,927
Liabilities
Short-term debt	$	1,855,003	$	1,855,003	$	1,793,825	$	1,793,825
Accrued interest payable	8,936		8,936		8,502		8,502
Margin payable	6,415		6,415		6,455		6,455
Guarantee obligation	22,704		22,702		7,201		7,201
Derivative liabilities	62,794		62,794		58,331		58,331
ABS issued⁽¹⁾
Fair value	996,820		996,820		—		—
Amortized cost	53,137		53,137		1,545,119		1,446,605
FHLBC long-term borrowings	1,343,023		1,343,023		495,860		495,860
Commercial secured borrowings	63,152		63,152		66,707		66,707
Convertible notes	492,500		461,053		492,500		492,188
Other long-term debt	139,500		83,700		139,500		101,835


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


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

During the years ended December 31, 2015 and 2014, we elected the fair value option for $236 million and $72 million of residential senior securities, $164 million and $9 million of residential subordinate securities, $10.21 billion and $8.81 billion of residential loans (principal balance), $618 million and $935 million of commercial loans (principal balance), $95 million and $96 million of MSRs, and zero and $7 million of guarantee assets, 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 December 31, 2015 and December 31, 2014, as well as the fair value hierarchy of the valuation inputs used to measure fair value.

Table 5.2 – Assets and Liabilities Measured at Fair Value on a Recurring Basis



December 31, 2015	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	3,927,370	$	—	$	129,819	$	3,797,551
Commercial loans	106,798		—		—		106,798
Trading securities	404,011		—		—		404,011
Available-for-sale securities	829,245		—		—		829,245
Derivative assets	16,393		2,734		8,988		4,671
MSRs	191,976		—		—		191,976
Pledged collateral	53,600		53,600		—		—
FHLBC stock	34,437		—		34,437		—
Guarantee asset	5,697		—		—		5,697
Liabilities
Derivative liabilities	62,794		2,963		58,368		1,463
Commercial secured borrowings	63,152		—		—		63,152
ABS issued	996,820		—		—		996,820



December 31, 2014	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	1,922,700	$	—	$	244,716	$	1,677,984
Commercial loans	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

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, 2015 and December 31, 2014.

Table 5.3 – 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
Acquisitions	5,231,532			617,519			399,990			33,370			95,281			—			—			—			—
Sales	(3,857,807		)	(754,636		)	(83,038		)	(366,373		)	(18,206		)	—			—			—			(1,362		)
Principal paydowns	(612,473		)	(780		)	(7,245		)	(131,387		)	—			—			—			(593		)	(312,800		)
Gains (losses) in net income, net	(6,071		)	7,199			(17,302		)	72,612			(24,392		)	(1,377		)	60,823			(3,011		)	8,366
Unrealized losses in OCI, net	—			—			—			(46,961		)	—			—			—			—			—
Other settlements, net⁽³⁾	(6,313		)	—			—			360			—			(127		)	(58,734		)	49			400
Ending balance - December 31, 2015	$	3,797,551		$	106,798		$	404,011		$	829,245		$	191,976		$	5,697		$	3,208		$	63,152		$	996,820



	Assets																				Liabilities
(In Thousands)	Residential Loans			Commercial Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset		Derivatives⁽¹⁾			Commercial Secured Borrowings
Beginning balance - December 31, 2013	$	391,100		$	89,111		$	124,555		$	1,558,306		$	64,824		$	—	$	(379	)	$	—
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		)	—			—		—			—
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			—			—		—			—
Other settlements, net ⁽³⁾	(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


(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.


(3)	Other settlements, net for derivatives represents the transfer of the fair value of loan purchase commitments at the time loans are acquired to the basis of residential loans.

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, 2015, 2014, and 2013. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the years ended December 31, 2015, 2014, and 2013 are not included in this presentation.

Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at December 31, 2015, 2014, and 2013 Included in Net Income



	Included in Net Income
	Years Ended December 31,
(In Thousands)	2015			2014			2013
Assets
Residential loans at Redwood	$	(5,541	)	$	16,512		$	(290	)
Residential loans at consolidated Sequoia entities	7,422			—			—
Commercial loans	(2,620		)	3,357			1,501
Trading securities	(13,391		)	(25,216		)	32,496
Available-for-sale securities	(246		)	(434		)	(1,108		)
MSRs	(3,471		)	(15,239		)	14,196
Loan purchase commitments	4,252			1,119			—
Guarantee asset	(1,504		)	—			—

Liabilities
Loan purchase commitments	$	—		$	—		$	(379	)
Commercial secured borrowing	3,011			2,033			—
ABS issued	(8,366		)	—			—

The following table presents information on assets recorded at fair value on a non-recurring basis at December 31, 2015 and December 31, 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 December 31, 2015 and December 31, 2014.

Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis



									Gain (Loss) for Year Ended
December 31, 2015	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		December 31, 2015
Assets
Residential loans, at lower of cost or fair value	$	1,096	$	—	$	—	$	1,096	$	3
REO	2,395		—		—		2,395		(764		)
Liabilities
Guarantee obligation	4,414		—		—		4,414		—

									Gain (Loss) for Year Ended
December 31, 2014	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		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		—

The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the years ended December 31, 2015, 2014, and 2013.

Table 5.6 – Market Valuation Gains and Losses, Net



	Years Ended December 31,
(In Thousands)	2015			2014			2013
Mortgage banking and investment activities, net
Residential loans held-for-sale, at fair value	$	3,712		$	51,312		$	(10,455	)
Residential loan purchase and forward sale commitments	50,234			13,891			(399		)
Residential loans held-for-investment at fair value, at Redwood	(6,337		)	(697		)	—
Consolidated Sequoia entities ⁽¹⁾	(1,192		)	(894		)	(612		)
Commercial loans, at fair value ⁽²⁾	10,265			20,788			8,694
Trading securities	(17,279		)	(24,197		)	38,926
Impairments on AFS securities	(246		)	(565		)	(1,833		)
Risk management derivatives, net	(52,146		)	(38,959		)	51,385
Guarantee asset	(1,504		)	—			—
Other investments	(382		)	104			—
Total mortgage banking and investment activities, net⁽³⁾	$	(14,875	)	$	20,783		$	85,706
MSR Income (loss), net
MSRs	$	(24,392	)	$	(21,081	)	$	11,995
Risk management derivatives, net	(12,708		)	—			—
Total MSR income (loss), net ⁽⁴⁾	$	(37,100	)	$	(21,081	)	$	11,995
Total market valuation gains and losses, net	$	(51,975	)	$	(298	)	$	97,701

(1)

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 includes 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 combined amount represents the estimated change in value of our retained interests in these entities. See Note 3 for further discussion.


(2)	Commercial loans at fair value does not include commercial A-notes, which were sold in 2014, but did not qualify for sale treatment under GAAP. The market valuation gains and losses on the commercial A-notes and associated commercial secured borrowings net to zero in each period presented.


(3)	Mortgage banking and investment activities, net presented above does not include fee income or provisions for repurchases that are components of mortgage banking and investment activities, net presented on our consolidated statements of income, as these amounts do not represent market valuation changes.


(4)	MSR Income (loss), net presented above does not include net fee income or provisions for repurchases that are components of MSR Income (loss), net on our consolidated statements of income, as these amounts do not represent market valuation adjustments.

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 groups using the valuation processes described below. 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 the methodology and 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.

Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments



December 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	$	1,936,062	Whole loan spread to TBA price	$	3.10		-	$	4.53		$	4.27

Jumbo hybrid loans	206,309		Prepayment rate (Annual CPR)	15			-	15		%	15		%
			Spread to swap rate	125			-	165		bps	138		bps

Jumbo loans committed to sell	633,310		Committed Sales Price	$	102.56		-	$	102.61		$	102.58

Loans held by consolidated Sequoia entities ⁽¹⁾	1,021,870		Liability price					N/A			N/A

Residential loans, at lower of cost or fair value	1,096		Loss severity	13			-	30		%	21		%

Commercial loans, at fair value	106,798		Spread to swap rate	221			-	221		bps	221		bps
			Credit support	26			-	26		%	26		%

Trading and AFS securities	1,233,256		Discount rate	5			-	12		%	6		%
			Prepayment rate (annual CPR)	1			-	35		%	12		%
			Default rate	0			-	35		%	6		%
			Loss severity	20			-	65		%	29		%
			Credit support	0			-	48		%	4		%

MSRs	191,976		Discount rate	9			-	12		%	10		%
			Prepayment rate (annual CPR)	5			-	60		%	10		%
			Per loan annual cost to service	$	72		-	$	82		$	79

Guarantee asset	5,697		Discount rate	11			-	11		%	11		%
			Prepayment rate (annual CPR)	12			-	12		%	12		%

REO	2,395		Loss severity	0			-	89		%	51		%

Loan purchase commitments, net ⁽²⁾	3,208		MSR Multiple	0			-	6		x	3.4		x
			Fallout rate	1			-	99		%	25		%
			Whole loan spread to TBA price	3.10			-	4.38			4.16
			Prepayment rate (Annual CPR)	15			-	15			15		%
			Spread to swap rate	125			-	165		bps	137		bps

Liabilities
ABS issued⁽¹⁾	996,820		Discount rate	5			-	9		%	5		%
			Prepayment rate (annual CPR)	2			-	23		%	12		%
			Default rate	1			-	12		%	7		%
			Loss severity	20			-	32		%	27		%
			Credit support	—			-	33		%	9		%

Commercial secured financing	63,152		Spread to swap rate	219			-	220		bps	220		bps
			Credit support	25		%	-	25		%	25		%

Notes to Table 5.7

(1)

Upon adoption of ASU 2014-13 on January 1, 2015, we began to record loans held-for-investment in, and ABS issued by, consolidated Sequoia entities at fair value. In accordance with this new guidance, the fair value of the loans in these entities was based on the fair value of the liabilities (ABS) 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 using models that incorporate various observable inputs, including pricing information from recent securitizations and whole loan sales. Certain significant inputs in these models are considered unobservable and are therefore Level 3 in nature. Pricing inputs obtained from market securitization activity include indicative spreads to indexed TBA prices for senior RMBS and indexed swap rates for subordinate RMBS (Level 3). Pricing inputs obtained from market whole loan transaction activity include indicative spreads to indexed TBA prices for fixed-rate loans and indexed swap rates for hybrid loans (Level 3). Other observable inputs include Agency RMBS transactions, benchmark interest rates, and prepayment rates. At December 31, 2015, our jumbo fixed-rate loans were priced exclusively using whole loan sale inputs. These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed, or credit support assumptions.

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 loans 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 collateral 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 default rates, serious delinquencies, 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 December 31, 2015, we received dealer price indications on 79% 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 1% of 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, loan purchase commitments ("LPCs"), and forward sale commitments ("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 for conforming loans 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 for conforming loans are obtained using quoted Agency prices. LPC fair values for jumbo loans are estimated based on the estimated fair values of the underlying loans (as described in "Residential loans" above) as well as the probability that the mortgage loan will be purchased (Level 3).

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 (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 were within 1% of 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 2).

Guarantee Asset

The guarantee asset represents the estimated fair value of cash flows we are contractually entitled to receive related to a risk sharing arrangement with Fannie Mae. Significant inputs in the valuation analysis are Level 3, due to the nature of this asset 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 prices 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 2).

Guarantee Obligations

In association with our risk sharing transactions with the Agencies we have made certain guarantees. For these transactions, at the close of each delivery period, or at quarter-end for open delivery periods, we recognize a liability representing the fair value of the guarantee obligation we assumed. Fair values of guarantee obligations are determined using internal models that incorporate certain significant inputs that are considered unobservable and are therefore Level 3 in nature. Pricing inputs include prepayment assumptions, loss assumptions, and discount rates. An increase in discount rates or loss rates, or a decrease in prepayment rates, would reduce the estimated fair value of the guarantee obligations.

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 2).

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. 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. For ABS issued, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. 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.

FHLBC Borrowings

FHLBC borrowings include amounts borrowed from the FHLBC that are secured, generally 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 2).

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).