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Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2019

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 June 30, 2019 and December 31, 2018.

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



	June 30, 2019				December 31, 2018
	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	$	1,056,178	$	1,056,178	$	1,048,690	$	1,048,690
At lower of cost or fair value	109		128		111		131
Residential loans, held-for-investment	6,227,078		6,227,078		6,205,941		6,205,941
Business purpose residential loans	250,854		250,854		141,258		141,258
Multifamily loans	3,749,657		3,749,657		2,144,598		2,144,598
Trading securities	1,205,389		1,205,389		1,118,612		1,118,612
Available-for-sale securities	272,097		272,097		333,882		333,882
Servicer advance investments ⁽¹⁾	259,222		259,222		300,468		300,468
MSRs ⁽¹⁾	47,396		47,396		60,281		60,281
Participation in loan warehouse facility ⁽¹⁾	—		—		39,703		39,703
Excess MSRs ⁽¹⁾	33,620		33,620		27,312		27,312
Cash and cash equivalents	218,145		218,145		175,764		175,764
Restricted cash	33,953		33,953		29,313		29,313
Accrued interest receivable	54,265		54,265		47,105		47,105
Derivative assets	26,609		26,609		35,789		35,789
REO ⁽²⁾	6,305		6,509		3,943		4,396
Margin receivable⁽²⁾	211,199		211,199		100,773		100,773
FHLBC stock ⁽²⁾	43,393		43,393		43,393		43,393
Guarantee asset⁽²⁾	1,999		1,999		2,618		2,618
Pledged collateral⁽²⁾	42,913		42,913		42,433		42,433
Liabilities
Short-term debt facilities	$	2,026,418	$	2,026,418	$	1,937,920	$	1,937,920
Short-term debt - servicer advance financing	236,231		236,231		262,740		262,740
Accrued interest payable	47,092		47,092		42,528		42,528
Margin payable ⁽³⁾	—		—		835		835
Guarantee obligation ⁽³⁾	15,744		15,456		16,711		16,774
Contingent consideration ⁽³⁾	24,932		24,932		—		—
Derivative liabilities	173,847		173,847		84,855		84,855
ABS issued at fair value	6,913,129		6,913,129		5,410,073		5,410,073
FHLBC long-term borrowings	1,999,999		1,999,999		1,999,999		1,999,999
Convertible notes, net	634,805		639,849		633,196		618,271
Trust preferred securities and subordinated notes, net	138,605		97,650		138,582		102,533


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


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


(3)	These liabilities are included in Accrued expenses and other liabilities on our consolidated balance sheets.

During the three and six months ended June 30, 2019, we elected the fair value option for $2 million and $34 million of residential senior securities, respectively, $86 million and $206 million of subordinate securities, respectively, $1.53 billion and $2.53 billion of residential loans (principal balance), respectively, $112 million and $177 million of business purpose residential loans (principal balance), respectively, zero and $69 million of servicer advance investments, respectively, and $5 million and $7 million of excess MSRs, respectively. We anticipate electing the fair value option for all future purchases of residential and business purpose residential loans that we intend to sell to third parties or transfer to securitizations, as well as 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 June 30, 2019 and December 31, 2018, 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



June 30, 2019	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	7,283,256	$	—	$	—	$	7,283,256
Business purpose residential loans	250,854		—		—		250,854
Multifamily loans	3,749,657		—		—		3,749,657
Trading securities	1,205,389		—		—		1,205,389
Available-for-sale securities	272,097		—		—		272,097
Servicer advance investments	259,222		—		—		259,222
MSRs	47,396		—		—		47,396
Excess MSRs	33,620		—		—		33,620
Derivative assets	26,609		1,784		19,258		5,567
Pledged collateral	42,913		42,913		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	1,999		—		—		1,999

Liabilities
Contingent consideration	$	24,932	$	—	$	—	$	24,932
Derivative liabilities	173,847		4,639		168,436		772
ABS issued	6,913,129		—		—		6,913,129



December 31, 2018	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	7,254,631	$	—	$	—	$	7,254,631
Business purpose residential loans	141,258		—		—		141,258
Multifamily loans	2,144,598		—		—		2,144,598
Trading securities	1,118,612		—		—		1,118,612
Available-for-sale securities	333,882		—		—		333,882
Servicer advance investments	300,468		—		—		300,468
MSRs	60,281		—		—		60,281
Excess MSRs	27,312		—		—		27,312
Derivative assets	35,789		4,665		28,211		2,913
Pledged collateral	42,433		42,433		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	2,618		—		—		2,618

Liabilities
Derivative liabilities	$	84,855	$	13,215	$	70,908	$	732
ABS issued	5,410,073		—		—		5,410,073

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the six months ended June 30, 2019.

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



	Assets
	Residential Loans			Business Purpose Residential Loans			Multifamily Loans			Trading Securities			AFS Securities			Servicer Advance Investments			MSRs			Excess MSRs			Guarantee Asset
(In Thousands)	Residential Loans			Business Purpose Residential Loans			Multifamily Loans			Trading Securities			AFS Securities			Servicer Advance Investments			MSRs			Excess MSRs			Guarantee Asset
Beginning balance - December 31, 2018	$	7,254,631		$	141,258		$	2,144,598		$	1,118,612		$	333,882		$	300,468		$	60,281		$	27,312		$	2,618
Acquisitions	2,583,951			29,093			1,481,554			240,478			8,954			68,976			868			6,810			—
Originations	—			169,562			—			—			—			—			—			—			—
Sales	(2,088,273		)	(43,548		)	—			(174,216		)	(67,001		)	—			—			—			—
Principal paydowns	(614,975		)	(43,931		)	(7,516		)	(14,836		)	(24,207		)	(111,662		)	—			—			—
Gains (losses) in net income, net	147,969			3,416			131,021			40,302			17,503			1,440			(13,753		)	(502		)	(619		)
Unrealized losses in OCI, net	—			—			—			—			2,966			—			—			—			—
Other settlements, net ⁽¹⁾	(47		)	(4,996		)	—			(4,951		)	—			—			—			—			—
Ending Balance - June 30, 2019	$	7,283,256		$	250,854		$	3,749,657		$	1,205,389		$	272,097		$	259,222		$	47,396		$	33,620		$	1,999

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



				Liabilities
	Derivatives ⁽²⁾			Contingent Consideration		ABS Issued
(In Thousands)	Derivatives ⁽²⁾			Contingent Consideration		ABS Issued
Beginning balance - December 31, 2018	$	2,181		$	—	$	5,410,073
Acquisitions	—			24,621		1,738,537
Principal paydowns	—			—		(416,791		)
Gains (losses) in net income, net	28,908			311		181,310
Other settlements, net ⁽¹⁾	(26,294		)	—		—
Ending Balance - June 30, 2019	$	4,795		$	24,932	$	6,913,129

(1)

Other settlements, net for residential and business purpose residential loans represents the transfer of loans to REO, and for derivatives, the settlement of forward sale commitments and the transfer of the fair value of loan purchase commitments at the time loans are acquired to the basis of residential loans. Other settlements, net for trading securities relates to the consolidation of a Freddie Mac K-Series entity during the second quarter of 2019.


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

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 June 30, 2019 and 2018. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and six months ended June 30, 2019 and 2018 are not included in this presentation.

Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at June 30, 2019 and 2018 Included in Net Income



	Included in Net Income
	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2019			2018			2019			2018
Assets
Residential loans at Redwood	$	48,575		$	(12,981	)	$	80,615		$	(51,029	)
Residential loans at consolidated Sequoia entities	6,772			367			21,243			20,914
Residential loans at consolidated Freddie Mac SLST entity	31,477			—			55,005			—
Business purpose residential loans	3,038			—			4,032			—
Multifamily loans at consolidated Freddie Mac K-Series entities	96,649			—			131,020			—
Trading securities	17,771			(1,989		)	38,658			(6,011		)
Available-for-sale securities	—			(56		)	—			(56		)
Servicer advance investments	432			—			1,440			—
MSRs	(7,334		)	689			(11,518		)	4,610
Excess MSRs	(66		)	—			(502		)	—
Loan purchase commitments	5,534			2,835			5,567			2,901
Other assets - Guarantee asset	(277		)	(120		)	(196		)	66

Liabilities
Loan purchase commitments	$	(756	)	$	(4,646	)	$	(772	)	$	(4,687	)
ABS issued	(121,127		)	(279		)	(181,310		)	(21,014		)

The following table presents information on assets recorded at fair value on a non-recurring basis at June 30, 2019. 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 sheets at June 30, 2019.

Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at June 30, 2019



									Gain (Loss) for
June 30, 2019	Carrying Value		Fair Value Measurements Using						Three Months Ended			Six Months Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		June 30, 2019			June 30, 2019
Assets
REO	$	5,732	$	—	$	—	$	5,732	$	(150	)	$	(422	)

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 and six months ended June 30, 2019 and 2018.

Table 5.6 – Market Valuation Gains and Losses, Net



	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2019			2018			2019			2018
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value	$	3,379		$	6,122		$	6,912		$	10,896
Residential loan purchase and forward sale commitments	16,888			(2,758		)	28,199			(9,726		)
Single-family rental loans held-for-sale, at fair value	1,313			—			2,917			—
Single-family rental loan purchase commitments	569			—			709			—
Residential bridge loans	1,012			—			1,098			—
Risk management derivatives, net	(7,431		)	6,150			(12,415		)	34,582
Total mortgage banking activities, net ⁽¹⁾	$	15,730		$	9,514		$	27,420		$	35,752
Investment Fair Value Changes, Net
Residential loans held-for-investment, at Redwood	$	35,548		$	(15,010	)	$	63,656		$	(53,995	)
Residential bridge loans held-for-investment	(318		)	—			(621		)	—
Trading securities	18,442			(930		)	40,302			(3,885		)
Servicer advance investments	432			—			1,440			—
Excess MSRs	(65		)	—			(502		)	—
REO	(139		)	—			(139		)	—
Net investments in Legacy Sequoia entities ⁽²⁾	(123		)	(720		)	(497		)	(728		)
Net investments in Sequoia Choice entities ⁽²⁾	2,879			1,072			6,144			986
Net investment in Freddie Mac SLST entity ⁽²⁾	8,037			—			14,402			—
Net investments in Freddie Mac K-Series entities ⁽²⁾	3,246			—			6,365			—
Risk-sharing investments	(61		)	(209		)	(138		)	(348		)
Risk management derivatives, net	(64,740		)	16,742			(107,115		)	60,524
Impairments on AFS securities	—			(56		)	—			(56		)
Total investment fair value changes, net	$	3,138		$	889		$	23,297		$	2,498
Other Income (Expense), Net
MSRs	$	(8,653	)	$	(745	)	$	(13,753	)	$	2,147
Risk management derivatives, net	6,517			(1,122		)	8,768			(6,261		)
Gain on re-measurement of 5 Arches investment	—			—			2,440			—
Total other expense, net ⁽³⁾	$	(2,136	)	$	(1,867	)	$	(2,545	)	$	(4,114	)
Total Market Valuation Gains, Net	$	16,732		$	8,536		$	48,172		$	34,136


(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)	Includes changes in fair value of the residential loans held-for-investment, REO and the ABS issued at the entities, which netted together represent the change in value of our investments at the consolidated VIEs.


(3)	Other income (expense), net presented above does not include net MSR fee income or provisions for repurchases for MSRs, as these amounts do not represent market valuation adjustments.

At June 30, 2019, 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, 2018. 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



June 30, 2019	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	$	2,724,429	Prepayment rate (annual CPR)	20		-	20		%	20		%
			Whole loan spread to TBA price	$	1.55	-	$	1.55		$	1.55
			Whole loan spread to swap rate	80		-	365		bps	179		bps

Jumbo hybrid loans	344,151		Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate	65		-	360		bps	141		bps

Jumbo loans committed to sell	374,481		Whole loan committed sales price	$	101.84	-	$	103.08		$	102.12

Loans held by Legacy Sequoia ⁽¹⁾	457,750		Liability price				N/A			N/A

Loans held by Sequoia Choice ⁽¹⁾	2,147,356		Liability price				N/A			N/A

Loans held by Freddie Mac SLST ⁽¹⁾	1,235,089		Liability price				N/A			N/A

Business purpose residential loans:
Single-family rental loans	91,501		IO discount rate	12		-	12		%	12		%
			Prepayment rate (annual CPR)	2		-	10		%	5		%
			Senior credit spread	95		-	95		bps	95		bps
			Subordinate credit spread	140		-	1,200		bps	306		bps
			Senior credit support	35		-	35		%	35		%

Residential bridge loans	159,353		Discount rate	7		-	8		%	7		%

Multifamily loans held by Freddie Mac K-Series ⁽¹⁾	3,749,657		Liability price				N/A			N/A

Trading and AFS securities	1,477,486		Discount rate	3		-	14		%	5		%
			Prepayment rate (annual CPR)	—		-	60		%	10		%
			Default rate	—		-	20		%	2		%
			Loss severity	—		-	40		%	21		%

Servicer advance investments	259,222		Discount rate	4		-	4		%	4		%
			Prepayment rate (annual CPR)	8		-	15		%	14		%
			Expected remaining life ⁽²⁾	2		-	2		years	2		years
			Mortgage servicing income	6		-	14		bps	10		bps

MSRs	47,396		Discount rate	11		-	17		%	11		%
			Prepayment rate (annual CPR)	5		-	45		%	12		%
			Per loan annual cost to service	$	82	-	$	82		$	82

Excess MSRs	33,620		Discount rate	11		-	16		%	14		%
			Prepayment rate (annual CPR)	8		-	14		%	11		%
			Excess mortgage servicing income	8		-	17		bps	12		bps

Guarantee asset	1,999		Discount rate	11		-	11		%	11		%
			Prepayment rate (annual CPR)	15		-	15		%	15		%

REO	5,732		Loss severity	3		-	52		%	7		%

Loan purchase commitments, net	4,707		MSR multiple	0.7		-	4.6		x	2.2		x
			Pull-through rate	7		-	100		%	70		%
			Whole loan spread to TBA price	$	0.61	-	$	1.55		$	1.54
			Whole loan spread to swap rate - fixed rate	115		-	365		bps	228		bps
			Prepayment rate (annual CPR)	15		-	20		%	18		%
			Whole loan spread to swap rate - hybrid	90		-	345		bps	129		bps

Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments (continued)



June 30, 2019	Fair Value		Input Values
(Dollars in Thousands, except Input Values)	Fair Value	Unobservable Input	Range				Weighted Average
Liabilities
ABS issued ⁽¹⁾:
At consolidated Sequoia entities	2,378,306	Discount rate	3	-	15	%	4	%
		Prepayment rate (annual CPR)	8	-	49	%	19	%
		Default rate	—	-	9	%	2	%
		Loss severity	20	-	22	%	21	%

At consolidated Freddie Mac SLST entity	991,766	Discount rate	3	-	8	%	3	%
		Prepayment rate (annual CPR)	6	-	6	%	6	%
		Default rate	2	-	2	%	2	%
		Loss severity	30	-	30	%	30	%

At consolidated Freddie Mac K-Series entities	3,543,057	Discount rate	2	-	9	%	3	%
		Prepayment rate (annual CPR)	—	-	—	%	—	%
		Default rate	1	-	1	%	1	%
		Loss severity	20	-	20	%	20	%

Contingent consideration	24,932	Discount rate	23	-	23	%	23	%
		Probability of outcomes ⁽³⁾	—	-	100	%	90	%


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


(2)	Represents the estimated average duration of outstanding servicer advances at a given point in time (not taking into account new advances made with respect to the pool).


(3)	Represents the probability of a full payout of contingent purchase consideration.

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 at Redwood

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. These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed, or credit support assumptions.

Residential and multifamily loans at consolidated entities

We have elected to account for our consolidated securitization entities as CFEs in accordance with GAAP. A CFE is a variable interest entity that holds financial assets and issues beneficial interests in those assets, and these beneficial interests have contractual recourse only to the related assets of the CFE. Accounting guidance for CFEs allow companies to elect to measure both the financial assets and financial liabilities of a CFE using the more observable of the fair value of the financial assets or fair value of the financial liabilities. Pursuant to this guidance, we use the fair value of the ABS issued by the CFEs (which we determined to be more observable) to determine the fair value of the loans held at these entities, whereby the net assets we consolidate in our financial statements related to these entities represent the estimated fair value of our retained interests in the CFEs.

Business purpose residential loans

Business purpose residential loans include single-family rental loans and residential bridge loans 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.

Prices for our single-family rental loans are determined using market comparable information. Significant inputs obtained from market activity include indicative spreads to indexed swap rates for senior and subordinate mortgage-backed securities ("MBS"), IO MBS discount rates, senior credit support levels, and assumed future prepayment rates (Level 3). These assets would generally decrease in value based upon an increase in the credit spread or prepayment speed assumptions.

Prices for our residential bridge loans are determined using discounted cash flow modeling, which incorporates a primary significant unobservable input of discount rate. These assets would generally decrease in value based upon an increase in the discount rate.

Real estate securities

Real estate securities include residential, multifamily, and other mortgage-backed securities that are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators that are factored into the 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 and loss severity. The estimated fair value of our securities would generally decrease based upon an increase in discount rate, default rates, loss severities, or a decrease in prepayment rates.

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 June 30, 2019, we received dealer price indications on 88% of our securities, representing 96% 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, 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. 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 and FSC fair values for residential jumbo and single-family rental loans are estimated based on the estimated fair values of the underlying loans (as described in "Residential loans at Redwood" and "Business purpose residential loans" above). In addition, fair values for LPCs are estimated based on 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).

Servicer advance investments

Estimated fair values for servicer advance investments are determined through internal pricing models that estimate future cash flows and utilize certain significant inputs that are considered unobservable and are therefore Level 3 in nature. Our estimations of cash flows include the combined cash flows of all of the components that comprise the servicer advance investments: existing advances, the requirement to purchase future advances, the recovery of advances, and the right to a portion of the associated mortgage servicing fee ("mortgage servicing income"). The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included prepayment rate (of the loans underlying the investments), mortgage servicing income, servicer advance WAL (the weighted-average expected remaining life of servicer advances), and discount rate. These assets would generally decrease in value based upon an increase in prepayment rates, an increase in servicer advance WAL, or an increase in discount rate, or a decrease in mortgage servicing income.

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 2% of the third-party valuation.

Excess MSRs

Estimated fair values for excess MSRs are determined through internal pricing models that estimate future cash flows and utilize certain significant inputs that are considered unobservable and are therefore Level 3 in nature. The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included prepayment rate (of the loans underlying the investments), the amount of excess servicing income expected to be received ("excess mortgage servicing income"), and discount rate. These assets would generally decrease in value based upon an increase in prepayment rates or discount rate, or a decrease in excess mortgage servicing income.

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, cash held in association with borrowings from the FHLBC, cash held at Servicing Investment entities, and cash held 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).

Real estate owned

Real estate owned ("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).

Contingent consideration

Contingent consideration is related to our acquisition of 5 Arches and is estimated and recorded at fair value as part of purchase consideration. Each reporting period we estimate the change in fair value of the contingent consideration, and such change is recognized in our consolidated statements of income, unless it is determined to be a measurement period adjustment. The estimate of the fair value of contingent consideration requires significant judgment and assumptions to be made about future operating results, discount rates, and probabilities of projected operating result scenarios (Level 3).

Short-term debt

Short-term debt includes our credit facilities for residential and business purpose residential loans and real estate securities as well as non-recourse short-term borrowings used to finance servicer advance investments. 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 Legacy Sequoia and Sequoia Choice securitization entities, as well as securities issued by certain third-party Freddie Mac SLST and K-series securitization entities which we consolidate. 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). These cash flow models use significant unobservable inputs such as a discount rates, prepayment rate, default rate, loss severity and credit support. 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 (i.e., 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).

Financial Instruments Carried at Amortized Cost

Participation in loan warehouse facility

Our participation in a loan warehouse facility was carried at amortized cost (Level 2).

Guarantee obligations

In association with our risk-sharing transactions with the Agencies, we have made certain guarantees which are carried on our balance sheet at amortized cost (Level 3).

Convertible notes

Convertible notes include unsecured convertible and exchangeable senior notes that are carried at their unpaid principal balance net of any unamortized deferred issuance costs. The fair value of the convertible notes is determined using quoted prices in generally active markets (Level 2).

Trust preferred securities and subordinated notes

Trust preferred securities and subordinated notes are carried at their unpaid principal balance net of any unamortized deferred issuance costs (Level 3).

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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