Fair Value of Financial Instruments

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of valuation hierarchy are defined as follows:

Level 1 — Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 — Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 — Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The following describes the valuation methodologies used for the Company’s financial instruments measured at fair value on a recurring basis, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Securities Obtained and Pledged as Collateral/Obligation to Return Securities Obtained as Collateral

The fair value of U.S. Treasury securities obtained as collateral and the associated obligation to return securities obtained as collateral are based upon prices obtained from a third-party pricing service, which are indicative of market activity. Securities obtained as collateral are classified as Level 1 in the fair value hierarchy.

MBS and CRT securities

The Company determines the fair value of its Agency MBS, based upon prices obtained from third-party pricing services, which are indicative of market activity and repurchase agreement counterparties.

For Agency MBS, the valuation methodology of the Company’s third-party pricing services incorporate commonly used market pricing methods, trading activity observed in the marketplace and other data inputs. The methodology also considers the underlying characteristics of each security, which are also observable inputs, including: collateral vintage, coupon, maturity date, loan age, reset date, collateral type, periodic and life cap, geography, and prepayment speeds. Management analyzes pricing data received from third-party pricing services and compares it to other indications of fair value including data received from repurchase agreement counterparties and its own observations of trading activity observed in the marketplace.

In determining the fair value of its Non-Agency MBS and CRT securities, management considers a number of observable market data points, including prices obtained from pricing services and brokers as well as dialogue with market participants. In valuing Non-Agency MBS, the Company understands that pricing services use observable inputs that include, in addition to trading activity observed in the marketplace, loan delinquency data, credit enhancement levels and vintage, which are taken into account to assign pricing factors such as spread and prepayment assumptions. For tranches of Legacy Non-Agency MBS that are cross-collateralized, performance of all collateral groups involved in the tranche are considered. The Company collects and considers current market intelligence on all major markets, including benchmark security evaluations and bid-lists throughout the day from various sources, when available.

The Company’s MBS and CRT securities are valued using various market data points as described above, which management considers directly or indirectly observable parameters. Accordingly, the Company’s MBS and CRT securities are classified as Level 2 in the fair value hierarchy.

Residential Whole Loans, at Fair Value

The Company determines the fair value of its residential whole loans held at fair value after considering portfolio valuations obtained from a third-party who specializes in providing valuations of residential mortgage loans and trading activity observed in the market place. The Company’s residential whole loans held at fair value are classified as Level 3 in the fair value hierarchy

Swaps

The Company determines the fair value of non-centrally cleared Swaps considering valuations obtained from a third-party pricing service. For Swaps that are cleared by a central clearing house valuations provided by the clearing house are used. All valuations obtained are tested with internally developed models that apply readily observable market parameters. The Company considers the creditworthiness of both the Company and its counterparties, along with collateral provisions contained in each derivative agreement, from the perspective of both the Company and its counterparties. All of the Company’s Swaps are subject either to bilateral collateral arrangements, or for cleared Swaps, to the clearing house’s margin requirements. Consequently, no credit valuation adjustment was made in determining the fair value of such instruments. Swaps are classified as Level 2 in the fair value hierarchy.

The following table presents the Company’s financial instruments carried at fair value on a recurring basis as of June 30, 2015, on the consolidated balance sheet by the valuation hierarchy, as previously described:



(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	5,331,211	$	—	$	5,331,211
Non-Agency MBS, including MBS transferred to consolidated VIEs	—		6,882,153		—		6,882,153
CRT securities	—		128,910		—		128,910
Securities obtained and pledged as collateral	498,336		—		—		498,336
Residential whole loans, at fair value	—		—		183,861		183,861
Swaps	—		849		—		849
Total assets carried at fair value	$	498,336	$	12,343,123	$	183,861	$	13,025,320
Liabilities:
Swaps	$	—	$	65,420	$	—	$	65,420
Obligation to return securities obtained as collateral	498,336		—		—		498,336
Total liabilities carried at fair value	$	498,336	$	65,420	$	—	$	563,756

The following table presents additional information for the three and six months ended June 30, 2015 about the Company’s Residential whole loans, at fair value, which are classified as Level 3 and measured at fair value on a recurring basis. The Company did not own any residential whole loans held at fair value during the three and six months ended June 30, 2014.

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



(In Thousands)	Three Months Ended June 30, 2015			Six Months Ended June 30, 2015

Balance at beginning of period	$	144,507		$	143,472
Purchases and capitalized advances	47,700			53,729
Changes in fair value recorded in Net gain on residential whole loans held at fair value	1,165			1,510
Collection of principal, net of liquidation gains/losses	(6,394		)	(8,570		)
Transfer to REO	(3,117		)	(6,280		)
Balance at end of period	$	183,861		$	183,861

The Company did not transfer any assets or liabilities from one level to another during the six months ended June 30, 2015.

The following table presents a summary of quantitative information about the significant unobservable inputs used in the fair value measurement of the Company’s residential whole loans held at fair value for which it has utilized Level 3 inputs to determine fair value as of June 30, 2015:

Fair Value Methodology for Level 3 Financial Instruments



	June 30, 2015
(Dollars in Thousands)	Fair Value		Valuation Technique	Unobservable Input	Range	Weighted Average

Residential whole loans, at fair value (1)	$	57,620	Discounted cash flow	Discount rate	6.00-7.50%	6.85		%
				Prepayment rate	0.25-10.20%	6.22		%
				Default rate	0.00-8.40%	3.08		%
				Loss severity	10.00-76.99%	19.79		%

	$	79,773	Liquidation model	Discount rate	6.75-6.75%	6.75		%
				Annual change in home prices	(3.58)-6.67%	0.62		%
				Liquidation timeline (in years)	1.00-4.17	1.69
				Current value of underlying properties	$29-$3,440		$452
Total	$	137,393


(1)	Excludes unsettled loan purchases as of June 30, 2015.

The following table presents the difference between the fair value and the aggregate unpaid principal balance of the Company’s residential whole loans for which the fair value option was elected, at June 30, 2015 and December 31, 2014:



	June 30, 2015							December 31, 2014
(In Thousands)	Fair Value		Unpaid Principal Balance		Difference			Fair Value		Unpaid Principal Balance		Difference
Residential whole loans, at fair value
Total loans	$	183,861	$	247,310	$	(63,449	)	$	143,472	$	182,613	$	(39,141	)
Loans 90 days or more past due	$	130,207	$	184,685	$	(54,478	)	$	128,591	$	165,358	$	(36,767	)

Changes to the valuation methodologies used with respect to the Company’s financial instruments are reviewed by management to ensure any such changes result in appropriate exit price valuations. The Company will refine its valuation methodologies as markets and products develop and pricing methodologies evolve. The methods described above may produce fair value estimates that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company believes its valuation methods are appropriate and consistent with those used by market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced. The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, and management may conclude that its financial instruments should be reclassified to a different level in the future.

The following table presents the carrying values and estimated fair values of the Company’s financial instruments at June 30, 2015 and December 31, 2014:



	June 30, 2015			December 31, 2014
	Carrying Value		Estimated Fair Value	Carrying Value		Estimated Fair Value
(In Thousands)	Carrying Value		Estimated Fair Value	Carrying Value		Estimated Fair Value
Financial Assets:
Agency MBS	$	5,331,211	5,331,211	$	5,904,207	$	5,904,207
Non-Agency MBS, including MBS transferred to consolidated VIEs	6,882,153		6,882,153	4,755,432		4,755,432
CRT securities	128,910		128,910	102,983		102,983
Securities obtained and pledged as collateral	498,336		498,336	512,105		512,105
Residential whole loans, at carrying value	245,402		261,925	207,923		217,386
Residential whole loans, at fair value	183,861		183,861	143,472		143,472
Cash and cash equivalents	218,492		218,492	182,437		182,437
Restricted cash	68,057		68,057	67,255		67,255
Linked Transactions	—		—	398,336		398,336
Swaps	849		849	3,136		3,136
Financial Liabilities:
Repurchase agreements	9,635,036		9,638,056	8,267,388		8,266,699
Securitized debt	62,320		62,558	110,574		110,791
Obligation to return securities obtained as collateral	498,336		498,336	512,105		512,105
Senior Notes	100,000		104,600	100,000		104,720
Swaps	65,420		65,420	62,198		62,198

In addition to the methodologies used to determine the fair value of the Company’s financial assets and liabilities reported at fair value on a recurring basis, as previously described, the following methods and assumptions were used by the Company in arriving at the fair value of the Company’s other financial instruments presented in the above table:

Residential Whole Loans at Carrying Value: The Company determines the fair value of its residential whole loans held at carrying value after considering portfolio valuations obtained from a third-party who specializes in providing valuations of residential mortgage loans and trading activity observed in the market place. The Company’s residential whole loans held at carrying value are classified as Level 3 in the fair value hierarchy.

Cash and Cash Equivalents and Restricted Cash: Cash and cash equivalents and restricted cash are comprised of cash held in overnight money market investments and demand deposit accounts. At June 30, 2015 and December 31, 2014, the Company’s money market funds were invested in securities issued by the U.S. Government, or its agencies, instrumentalities, and sponsored entities, and repurchase agreements involving the securities described above. Given the overnight term and assessed credit risk, the Company’s investments in money market funds are determined to have a fair value equal to their carrying value.

Linked Transactions: As previously discussed, new accounting guidance that was effective for the Company on January 1, 2015 prospectively eliminated the use of Linked Transaction accounting, and as a result, the Company did not have any Linked Transactions at June 30, 2015. The Non-Agency MBS that prior to January 1, 2015 were accounted for as a component of Linked Transactions were valued using similar techniques to those used for the Company’s other Non-Agency MBS. The value of the underlying MBS was then netted against the carrying amount (which approximates fair value) of the repurchase agreement borrowing at the valuation date. The fair value of Linked Transactions also included accrued interest receivable on the MBS and accrued interest payable on the underlying repurchase agreement borrowings. The Company’s Linked Transactions were classified as Level 2 in the fair value hierarchy at December 31, 2014.

Repurchase Agreements: The fair value of repurchase agreements reflects the present value of the contractual cash flows discounted at market interest rates at the valuation date for repurchase agreements with a term equivalent to the remaining term to interest rate repricing, which may be at maturity. Such interest rates are estimated based on LIBOR rates observed in the market. The Company’s repurchase agreements are classified as Level 2 in the fair value hierarchy.

Securitized Debt: In determining the fair value of securitized debt, management considers a number of observable market data points, including prices obtained from pricing services and brokers as well as dialogue with market participants. Accordingly, the Company’s securitized debt is classified as Level 2 in the fair value hierarchy.

Senior Notes: The fair value of the Senior Notes is determined using the end of day market price quoted on the NYSE at the reporting date. The Company’s Senior Notes are classified as Level 1 in the fair value hierarchy.