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, 2017 and December 31, 2016.

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



	March 31, 2017				December 31, 2016
	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	$	375,407	$	375,407	$	834,193	$	834,193
At lower of cost or fair value	1,200		1,354		1,206		1,365
Residential loans, held-for-investment
At fair value	3,095,634		3,095,634		3,052,652		3,052,652
Trading securities	591,152		591,152		445,687		445,687
Available-for-sale securities	574,788		574,788		572,752		572,752
MSRs	111,013		111,013		118,526		118,526
Cash and cash equivalents	221,781		221,781		212,844		212,844
Restricted cash	1,929		1,929		8,623		8,623
Accrued interest receivable	17,645		17,645		18,454		18,454
Derivative assets	26,660		26,660		36,595		36,595
REO ⁽¹⁾	3,953		4,183		5,533		5,560
Margin receivable⁽¹⁾	83,229		83,229		68,038		68,038
FHLBC stock ⁽¹⁾	43,393		43,393		43,393		43,393
Guarantee asset⁽¹⁾	3,846		3,846		4,092		4,092
Commercial loans ⁽¹⁾	2,700		2,700		2,700		2,700
Pledged collateral⁽¹⁾	42,916		42,916		42,875		42,875
Liabilities
Short-term debt	$	563,773	$	563,773	$	791,539	$	791,539
Accrued interest payable	16,035		16,035		9,608		9,608
Margin payable	3,394		3,394		12,783		12,783
Guarantee obligation	21,082		21,764		21,668		22,181
Derivative liabilities	66,867		66,867		66,329		66,329
ABS issued at fair value, net	728,391		728,391		773,462		773,462
FHLBC long-term borrowings	1,999,999		1,999,999		1,999,999		1,999,999
Convertible notes, net	482,994		496,820		482,195		493,365
Trust preferred securities and subordinated notes, net	138,501		101,138		138,489		96,255


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

During the three months ended March 31, 2017, we elected the fair value option for $3 million of residential senior securities, $142 million of subordinate securities, $1.09 billion of residential loans (principal balance), and $7 million of MSRs. We anticipate electing the fair value option for all future purchases of residential loans that we intend to sell to third parties or transfer to securitizations, for MSRs purchased or retained from sales of residential loans, and for certain securities we purchase, including IO securities and fixed-rate securities rated investment grade or higher.

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, 2017 and December 31, 2016, 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



March 31, 2017	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	3,471,041	$	—	$	—	$	3,471,041
Trading securities	591,152		—		—		591,152
Available-for-sale securities	574,788		—		—		574,788
Derivative assets	26,660		9,548		11,552		5,560
MSRs	111,013		—		—		111,013
Pledged collateral	42,916		42,916		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	3,846		—		—		3,846

Liabilities
Derivative liabilities	$	66,867	$	9,798	$	56,296	$	773
ABS issued	728,391		—		—		728,391



December 31, 2016	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	3,886,845	$	—	$	—	$	3,886,845
Trading securities	445,687		—		—		445,687
Available-for-sale securities	572,752		—		—		572,752
Derivative assets	36,595		8,300		24,980		3,315
MSRs	118,526		—		—		118,526
Pledged collateral	42,875		42,875		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	4,092		—		—		4,092

Liabilities
Derivative liabilities	$	66,329	$	5,609	$	56,919	$	3,801
ABS issued	773,462		—		—		773,462

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, 2017.

Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis



	Assets																		Liabilities
	Residential Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives⁽¹⁾			ABS Issued
(In Thousands)	Residential Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives⁽¹⁾			ABS Issued
Beginning balance - December 31, 2016	$	3,886,845		$	445,687		$	572,752		$	118,526		$	4,092		$	(486	)	$	773,462
Acquisitions	1,108,332			145,396			25,333			7,485			—			—			—
Sales	(1,377,574		)	(8,279		)	(18,456		)	(11,928		)	—			—			—
Principal paydowns	(160,102		)	(2,836		)	(14,693		)	—			—			—			(55,609		)
Gains (losses) in net income, net	14,504			11,184			10,848			(3,070		)	(246		)	10,265			10,538
Unrealized losses in OCI, net	—			—			(996		)	—			—			—			—
Other settlements, net⁽²⁾	(964		)	—			—			—			—			(4,992		)	—
Ending Balance - March 31, 2017	$	3,471,041		$	591,152		$	574,788		$	111,013		$	3,846		$	4,787		$	728,391


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


(2)	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 March 31, 2017 and 2016. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three months ended March 31, 2017 and 2016 are not included in this presentation.

Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at March 31, 2017 and 2016 Included in Net Income



	Included in Net Income
	Three Months Ended March 31,
(In Thousands)	2017			2016
Assets
Residential loans at Redwood	$	3,723		$	27,285
Residential loans at consolidated Sequoia entities	8,414			(35,656		)
Commercial loans	—			2,171
Trading securities	10,051			(6,135		)
Available-for-sale securities	(117		)	—
MSRs	(916		)	(30,834		)
Loan purchase commitments	4,823			4,644
Other assets - Guarantee asset	(246		)	(1,425		)

Liabilities
Commercial secured borrowing	—			2,171
ABS issued	(10,538		)	33,515

The following table presents information on assets recorded at fair value on a non-recurring basis at March 31, 2017. 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 consolidated balance sheet at March 31, 2017.

Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at March 31, 2017



									Gain (Loss) for
March 31, 2017	Carrying Value		Fair Value Measurements Using						Three Months Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		March 31, 2017
Assets
Residential loans, at lower of cost or fair value	$	862	$	—	$	—	$	862	$	2
Commercial loans, at lower of cost or fair value	2,700		—		—		2,700		—
REO	3,255		—		—		3,255		(674		)

The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the three months ended March 31, 2017 and 2016.

Table 5.6 – Market Valuation Gains and Losses, Net



	Three Months Ended March 31,
(In Thousands)	2017			2016
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value	$	8,532		$	5,439
Residential loan purchase commitments	10,265			12,635
Commercial loans, at fair value	—			433
Sequoia securities	—			1,484
Risk management derivatives, net	(1,400		)	(12,754		)
Total mortgage banking activities, net ⁽¹⁾	$	17,397		$	7,237
Investment Fair Value Changes, Net
Residential loans held-for-investment at Redwood	$	(2,333	)	$	23,463
Trading securities	11,143			(5,601		)
Net investments in consolidated Sequoia entities	(1,810		)	(1,580		)
Risk sharing investments	(205		)	(10		)
Risk management derivatives, net	(5,127		)	(35,810		)
Impairments on AFS securities	(117		)	—
Total investment fair value changes, net	$	1,551		$	(19,538	)
MSR Income (Loss), Net
MSRs	$	(3,070	)	$	(44,604	)
Risk management derivatives, net	(749		)	41,057
Total MSR loss, net ⁽²⁾	$	(3,819	)	$	(3,547	)
Total Market Valuation Gains (Losses), Net	$	15,129		$	(15,848	)


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


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

At March 31, 2017, our valuation policy and processes had not changed from those described in our Annual Report on Form 10-K for the year ended December 31, 2016. 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



March 31, 2017	Fair Value			Input Values
(Dollars in Thousands, except Input Values)	Fair Value		Unobservable Input	Range						Weighted Average
Assets
Residential loans, at fair value:
Jumbo fixed-rate loans	$	2,438,357	Whole loan spread to TBA price	$	3.00	-	$	4.13		$	3.76
			Whole loan spread to swap rate	190		-	285		bps	271		bps

Jumbo hybrid loans	66,842		Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate	115		-	230		bps	171		bps

Jumbo loans committed to sell	220,221		Whole loan committed sales price	$	100.27	-	$	102.23		$	102.07

Loans held by consolidated Sequoia entities⁽¹⁾	745,621		Liability price				N/A			N/A

Residential loans, at lower of cost or fair value	862		Loss severity	15		-	30		%	20		%

Trading and AFS securities	1,165,940		Discount rate	4		-	12		%	8		%
			Prepayment rate (annual CPR)	1		-	56		%	17		%
			Default rate	—		-	19		%	2		%
			Loss severity	20		-	64		%	22		%
			Credit support	—		-	48		%	3		%

MSRs	111,013		Discount rate	10		-	16		%	11		%
			Prepayment rate (annual CPR)	4		-	34		%	9		%
			Per loan annual cost to service	$	82	-	$	82		$	82

Guarantee asset	3,846		Discount rate	11		-	11		%	11		%
			Prepayment rate (annual CPR)	10		-	10		%	10		%

REO	3,255		Loss severity	6		-	100		%	34		%

Loan purchase commitments, net ⁽²⁾	4,787		MSR multiple	0.7		-	5.5		x	3.5		x
			Pull-through rate	12		-	100		%	69		%
			Whole loan spread to TBA price	$	2.84	-	$	4.13		$	4.09
			Whole loan spread to swap rate - fixed rate	190		-	285		bps	280		bps
			Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate - hybrid	115		-	230		bps	141		bps

Liabilities
ABS issued ⁽¹⁾	728,391		Discount rate	4		-	8		%	5		%
			Prepayment rate (annual CPR)	2		-	20		%	16		%
			Default rate	1		-	12		%	7		%
			Loss severity	20		-	32		%	27		%
			Credit support	—		-	80		%	9		%


(1)	The fair value of the loans held by consolidated Sequoia entities was based on the fair value of the ABS issued by these entities, which we determined were more readily observable, in accordance with accounting guidance for collateralized financing entities.


(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 whole loan sales and securitizations. Certain significant inputs in these models are considered unobservable and are therefore Level 3 in nature. Pricing inputs obtained from market whole loan transaction activity include indicative spreads to indexed to be announced ("TBA") prices and indexed swap rates for fixed-rate loans and indexed swap rates for hybrid loans (Level 3). Pricing inputs obtained from market securitization activity include indicative spreads to indexed TBA prices for senior residential mortgage-backed securities ("RMBS") and indexed swap rates for subordinate RMBS, and credit support levels (Level 3). Other unobservable inputs also include assumed future prepayment rates. Observable inputs include benchmark interest rates, swap rates, and TBA prices. At March 31, 2017, our jumbo fixed-rate loans that were not committed to sell were priced 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.

Commercial loans

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. In certain cases, commercial loans are valued based on third-party offers for the loans (Level 2). An increase in market discount rates would generally 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 analysis 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 March 31, 2017, we received dealer price indications on 73% of our securities, representing 79% 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, and loan purchase commitments ("LPCs"). 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. Fair values of TBAs and financial futures 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 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 (the "Pull-through rate") (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. 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 market discount rates, assumed future prepayment rates of serviced loans, and the market cost of servicing. An increase in these unobservable inputs would generally 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 FHLB-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 unobservable inputs include assumed future prepayment rates and market discount rate (Level 3). An increase in prepayment rates or discount rate would generally 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 related to risk sharing transactions with the Agencies as well as at consolidated Sequoia 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. These obligations are initially recorded at fair value and subsequently carried at amortized cost. 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 assumed future prepayment rates, credit losses, and market discount rates. A decrease in future prepayment rates or discount rates, or an increase in credit losses, would generally cause the fair value of the guarantee obligations to decrease (become a larger liability).

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 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 analysis 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). A decrease in credit losses or discount rate, or an increase in prepayment rates, would generally cause the fair value of the ABS issued to decrease (become a larger liability).

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).

Convertible notes

Convertible notes include unsecured convertible and exchangeable senior notes. Fair values are determined using quoted prices in generally 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).