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 the Company’s 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 from various sources, when available.

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

Term Notes Backed by MSR Related Collateral

The Company’s valuation process for term notes backed by MSR related collateral considers a number of factors, including a comparable bond analysis performed by a third-party pricing service which involves determining a pricing spread at issuance of the term note. The pricing spread is used at each subsequent valuation date to determine an implied yield to maturity of the term note, which is used to derive an indicative market value for the security. This indicative market value is further reviewed by the Company and may be adjusted to ensure it reflects a realistic exit price at the valuation date given the structural features of these securities. At June 30, 2018, the indicative implied yields used in the valuation of these securities ranged from 5.6% to 6.8%. The weighted average indicative yield to maturity was 5.96%. Other factors taken into consideration include indicative values provided by repurchase agreement counterparties, estimated changes in fair value of the related underlying MSR collateral and the financial performance of the ultimate parent or sponsoring entity of the issuer, which has provided a guarantee that is intended to provide for payment of interest and principal to the holders of the term notes should cash flows generated by the related underlying MSR collateral be insufficient. As this process includes significant unobservable inputs, these securities are classified as Level 3 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 valuations obtained from a third-party that specializes in providing valuations of residential mortgage loans trading activity observed in the marketplace. The Company’s residential whole loans held at fair value are classified as Level 3 in the fair value hierarchy.

Swaps

All of the Company’s Swaps are cleared by a central clearing house. Valuations provided by the clearing house are used for purposes of determining the fair value of the Company’s Swaps. Such valuations obtained are tested with internally developed models that apply readily observable market parameters. As the Company’s Swaps are subject to the clearing house’s margin requirements, no credit valuation adjustment was considered necessary in determining the fair value of such instruments. Beginning in January 2017, variation margin payments on the Company’s cleared Swaps are treated as a legal settlement of the exposure under the Swap contract. Previously such payments were treated as collateral pledged against the exposure under the Swap contract. The effect of this change is to reduce what would have otherwise been reported as fair value of the Swap. Swaps are classified as Level 2 in the fair value hierarchy.

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 tables present the Company’s financial instruments carried at fair value on a recurring basis as of June 30, 2018 and December 31, 2017, on the consolidated balance sheets by the valuation hierarchy, as previously described:

Fair Value at June 30, 2018



(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	2,362,897	$	—	$	2,362,897
Non-Agency MBS	—		3,242,967		—		3,242,967
CRT securities	—		571,955		—		571,955
Term notes backed by MSR related collateral	—		—		381,390		381,390
Residential whole loans, at fair value	—		—		1,502,986		1,502,986
Securities obtained and pledged as collateral	253,721		—		—		253,721
Swaps	—		11,183		—		11,183
Total assets carried at fair value	$	253,721	$	6,189,002	$	1,884,376	$	8,327,099
Liabilities:
Obligation to return securities obtained as collateral	$	253,721	$	—	$	—	$	253,721
Total liabilities carried at fair value	$	253,721	$	—	$	—	$	253,721

Fair Value at December 31, 2017



(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	2,824,681	$	—	$	2,824,681
Non-Agency MBS	—		3,533,966		—		3,533,966
CRT securities	—		664,403		—		664,403
Term notes backed by MSR related collateral	—		—		381,804		381,804
Residential whole loans, at fair value	—		—		1,325,115		1,325,115
Securities obtained and pledged as collateral	504,062		—		—		504,062
Swaps	—		679		—		679
Total assets carried at fair value	$	504,062	$	7,023,729	$	1,706,919	$	9,234,710
Liabilities:
Obligation to return securities obtained as collateral	$	504,062	$	—	$	—	$	504,062
Total liabilities carried at fair value	$	504,062	$	—	$	—	$	504,062

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

The following table presents additional information for the three and six months ended June 30, 2018 and 2017 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:



	Residential Whole Loans, at Fair Value (1)
	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2018			2017			2018			2017
Balance at beginning of period	$	1,555,619		$	775,152		$	1,325,115		$	814,682
Purchases and capitalized advances	6,175			4,831			317,300			10,164
Changes in fair value recorded in Net gain on residential whole loans held at fair value	4,599			4,262			18,346			7,209
Collection of principal, net of liquidation gains/losses	(54,184		)	(15,652		)	(100,868		)	(35,695		)
Repurchases	(867		)	(450		)	(1,061		)	(756		)
Transfer to REO	(42,802		)	(24,071		)	(90,292		)	(51,532		)
Balance at end of period	$	1,468,540		$	744,072		$	1,468,540		$	744,072

(1) Excludes approximately $34.4 million and $239.2 million of residential whole loans held at fair value for which the closing of the purchase transaction had not occurred as of June 30, 2018 and 2017, respectively.

The following table presents additional information for the three and six months ended June 30, 2018 and 2017 about the Company’s investments in term notes backed by MSR related collateral held at fair value, which are classified as Level 3 and measured at fair value on a recurring basis:



	Term Notes Backed by MSR Related Collateral
	Three Months Ended June 30,					Six Months Ended June 30,
(In Thousands)	2018		2017			2018			2017 (1)
Balance at beginning of period	$	332,040	$	282,332		$	381,804		$	—
Purchases	49,350		—			149,350			150,000
Collection of principal	—		(8,371		)	(150,000		)	(17,019		)
Changes in unrealized gain/losses	—		—			236			—
Transfers from Level 2 to Level 3 (1)	—		—			—			140,980
Balance at end of period	$	381,390	$	273,961		$	381,390		$	273,961

(1) Investments in term notes backed by MSR related collateral were transferred from Level 2 to Level 3 during the six months ended June 30, 2017 as there had been very limited secondary market trading in these securities since issuance. Transfers between levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.

The Company did not transfer any assets or liabilities from one level to another during the three and six months ended June 30, 2018 and the three months ended June 30, 2017.

Fair Value Methodology for Level 3 Financial Instruments

Residential Whole Loans, at Fair Value

The following tables present 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, 2018 and December 31, 2017:



	June 30, 2018
(Dollars in Thousands)	Fair Value (1)		Valuation Technique	Unobservable Input	Weighted Average (2)			Range

Residential whole loans, at fair value	$	673,765	Discounted cash flow	Discount rate	5.5		%	4.5-8.2%
				Prepayment rate	3.9		%	0.9-13.5%
				Default rate	2.5		%	0.0-20.8%
				Loss severity	13.0		%	0.0-100.0%

	$	794,715	Liquidation model	Discount rate	8.2		%	6.1-50.0%
				Annual change in home prices	3.1		%	(0.6)-11.2%
				Liquidation timeline (in years)	1.8			0.1-4.5
				Current value of underlying properties (3)	$	829		$1-$12,400
Total	$	1,468,480



	December 31, 2017
(Dollars in Thousands)	Fair Value (1)		Valuation Technique	Unobservable Input	Weighted Average (2)			Range

Residential whole loans, at fair value	$	358,871	Discounted cash flow	Discount rate	5.5		%	4.5-13.0%
				Prepayment rate	4.1		%	1.15-15.1%
				Default rate	2.9		%	0.0-6.5%
				Loss severity	13.8		%	0.0-100.0%

	$	592,940	Liquidation model	Discount rate	8.0		%	6.1-50.0%
				Annual change in home prices	2.5		%	(8.0)-8.8%
				Liquidation timeline (in years)	1.6			0.1-4.5
				Current value of underlying properties (3)	$	772		$0-$9,900
Total	$	951,811

(1) Excludes approximately $34.5 million and $373.3 million of loans for which management considers the purchase price continues to reflect the fair value of such loans at June 30, 2018 and December 31, 2017, respectively.

(2) Amounts are weighted based on the fair value of the underlying loan.

(3) The simple average value of the properties underlying residential whole loans held at fair value valued via a liquidation model was approximately$384,000 and $336,000 as of June 30, 2018 and December 31, 2017, respectively.

The following table presents the carrying values and estimated fair values of the Company’s financial instruments at June 30, 2018 and December 31, 2017:



	June 30, 2018				December 31, 2017
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
(In Thousands)
Financial Assets:
Agency MBS	$	2,362,897	$	2,362,897	$	2,824,681	$	2,824,681
Non-Agency MBS	3,242,967		3,242,967		3,533,966		3,533,966
CRT securities	571,955		571,955		664,403		664,403
MSR related assets	381,390		381,390		492,080		493,026
Residential whole loans, at carrying value	1,906,242		1,987,218		908,516		988,688
Residential whole loans, at fair value	1,502,986		1,502,986		1,325,115		1,325,115
Securities obtained and pledged as collateral	253,721		253,721		504,062		504,062
Cash and cash equivalents	54,880		54,880		449,757		449,757
Restricted cash	3,298		3,298		13,307		13,307
Swaps	11,183		11,183		679		679
Financial Liabilities (1):
Repurchase agreements	5,892,228		5,900,049		6,614,701		6,623,255
Securitized debt	518,655		518,659		363,944		366,109
Obligation to return securities obtained as collateral	253,721		253,721		504,062		504,062
Senior Notes	96,794		102,231		96,773		103,729

(1) Carrying value of securitized debt, Senior Notes and certain repurchase agreements is net of associated debt issuance costs.

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 discussed on pages 43-48, 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 that are not reported at fair value on a recurring basis:

Residential Whole Loans, at Carrying Value: The Company generally 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. Given the short duration of the Company’s Rehabilitation loans, these investments are determined to have a carrying value which approximates fair value. 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, 2018 and December 31, 2017, 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.

Corporate Loan: The Corporate loan was repaid during the three months ended June 30, 2018. The Company had determined the fair value of this loan at December 31, 2017 after considering recent past and expected future loan performance, recent financial performance of the borrower and estimates of the current value of the underlying collateral which included certain MSRs and other assets of the borrower that had been pledged to secure the borrowing. The Company’s investment in this term loan was classified as Level 3 in the fair value hierarchy.

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.

The Company holds REO at the lower of the current carrying amount or fair value less estimated selling costs. At June 30, 2018 and December 31, 2017, the Company’s REO had an aggregate carrying value of $192.2 million and $152.4 million, and an aggregate estimated fair value of $214.8 million and $175.8 million, respectively. The Company classifies fair value measurements of REO as Level 3 in the fair value hierarchy.