Fair Value of Financial Instruments

GAAP requires the categorization of fair value measurements into three broad levels that form a hierarchy. 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.

Residential Mortgage 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.

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. The valuation approach applied generally depends on whether the loan is considered performing or non-performing at the date the valuation is performed. For performing loans, estimates of fair value are derived using a discounted cash flow approach, where estimates of cash flows are determined from the scheduled payments, adjusted using forecasted prepayment, default and loss given default rates. For non-performing loans, asset liquidation cash flows are derived based on the estimated time to liquidate the loan, expected costs and home price appreciation. Estimated cash flows for both performing and non-performing loans are discounted at yields considered appropriate to arrive at a reasonable exit price for the asset. Indications of loan value such as actual trades, bids, offers and generic market color may be used in determining the appropriate discount yield. The Company’s residential whole loans held at fair value are classified as Level 3 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 obtaining market quotes from a third-party pricing service. 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. 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, as applicable, 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, due to the relative illiquidity of the market, these securities 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 the 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 March 31, 2019 and December 31, 2018, on the consolidated balance sheets by the valuation hierarchy, as previously described:

Fair Value at March 31, 2019



(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	2,546,597	$	—	$	2,546,597
Non-Agency MBS	—		3,099,272		—		3,099,272
CRT securities	—		423,702		—		423,702
Residential whole loans, at fair value	—		—		1,512,337		1,512,337
Term notes backed by MSR-related collateral	—		—		753,594		753,594
Total assets carried at fair value	$	—	$	6,069,571	$	2,265,931	$	8,335,502

Fair Value at December 31, 2018



(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	2,698,213	$	—	$	2,698,213
Non-Agency MBS	—		3,318,299		—		3,318,299
CRT securities	—		492,821		—		492,821
Residential whole loans, at fair value	—		—		1,665,978		1,665,978
Term notes backed by MSR-related collateral	—		—		538,499		538,499
Total assets carried at fair value	$	—	$	6,509,333	$	2,204,477	$	8,713,810

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

The following table presents additional information for the three months ended March 31, 2019 and 2018 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
	Three Months Ended March 31,
(In Thousands)	2019			2018
Balance at beginning of period	$	1,471,263		$	1,325,115
Purchases and capitalized advances (1)	130,089			311,125
Changes in fair value recorded in Net gain on residential whole loans measured at fair value through earnings	(1,060		)	13,747
Collection of principal, net of liquidation gains/losses	(31,751		)	(46,683		)
Repurchases	(318		)	(194		)
Transfer to REO	(55,886		)	(47,490		)
Balance at end of period	$	1,512,337		$	1,555,620

(1)

Included in the activity presented for the three months ended March 31, 2019 is an adjustment of $70.6 million for loans the Company committed to purchase during the three months ended December 31, 2018, but for which the closing of the purchase transaction occurred during the three months ended March 31, 2019. The adjustment was required following the finalization of due diligence performed prior to the closing of the purchase transaction and resulted in a downward revision to the prior estimate of the loan purchase amount.

The following table presents additional information for the three months ended March 31, 2019 and 2018 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 March 31,
(In Thousands)	2019			2018
Balance at beginning of period	$	538,499		$	381,804
Purchases	219,166			100,000
Collection of principal	(4,584		)	(150,000		)
Changes in unrealized gain/losses	513			236
Balance at end of period	$	753,594		$	332,040

The Company did not transfer any assets or liabilities from one level to another during the three months ended March 31, 2019 and 2018.

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 March 31, 2019 and December 31, 2018:



	March 31, 2019
(Dollars in Thousands)	Fair Value (1)		Valuation Technique	Unobservable Input	Weighted Average (2)			Range

Residential whole loans, at fair value	$	744,578	Discounted cash flow	Discount rate	5.2		%	4.5-8.0%
				Prepayment rate	4.9		%	0.9-16.7%
				Default rate	4.2		%	0.0-24.1%
				Loss severity	12.8		%	0.0-100.0%

	$	641,522	Liquidation model	Discount rate	8.1		%	6.1-50.0%
				Annual change in home prices	3.5		%	0.0-8.6%
				Liquidation timeline (in years)	1.8			0.1-4.5
				Current value of underlying properties (3)	$	741		$2-$5,450
Total	$	1,386,100



	December 31, 2018
(Dollars in Thousands)	Fair Value (1)		Valuation Technique	Unobservable Input	Weighted Average (2)			Range

Residential whole loans, at fair value	$	700,250	Discounted cash flow	Discount rate	5.2		%	4.5-8.0%
				Prepayment rate	4.8		%	0.9-15.9%
				Default rate	4.1		%	0.0-24.1%
				Loss severity	12.9		%	0.0-100.0%

	$	683,252	Liquidation model	Discount rate	8.0		%	6.1-50.0%
				Annual change in home prices	3.5		%	(0.5)-12.2%
				Liquidation timeline (in years)	1.8			0.1-4.5
				Current value of underlying properties (3)	$	802		$2-$7,950
Total	$	1,383,502

(1) Excludes approximately $126.2 million and $282.5 million of loans for which management considers the purchase price continues to reflect the fair value of such loans at March 31, 2019 and December 31, 2018, 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$362,000 and $400,000 as of March 31, 2019 and December 31, 2018, respectively.

The following table presents the carrying values and estimated fair values of the Company’s financial instruments at March 31, 2019 and December 31, 2018:



	March 31, 2019				December 31, 2018
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
(In Thousands)
Financial Assets:
Agency MBS	$	2,546,597	$	2,546,597	$	2,698,213	$	2,698,213
Non-Agency MBS	3,099,272		3,099,272		3,318,299		3,318,299
CRT securities	423,702		423,702		492,821		492,821
Residential whole loans, at carrying value	3,724,146		3,816,290		3,016,715		3,104,401
Residential whole loans, at fair value	1,512,337		1,512,337		1,665,978		1,665,978
MSR-related assets	825,363		825,363		611,807		611,807
Cash and cash equivalents	76,579		76,579		51,965		51,965
Restricted cash	41,999		41,999		36,744		36,744
Financial Liabilities (1):
Repurchase agreements	8,509,713		8,527,163		7,879,087		7,895,672
Securitized debt	659,184		659,804		684,420		680,209
Senior Notes	96,827		102,591		96,816		99,951

(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 42-46, 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 using the same approach applied for residential whole loans held at fair value. 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 March 31, 2019 and December 31, 2018, 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 and are classified as Level 1 in the fair value hierarchy.

Corporate Loans: The Company determines the fair value of its Corporate loans, included in MSR-related assets along with the term notes, 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 includes certain MSRs and other assets of the borrower that are pledged to secure the borrowing. The Company’s investment in Corporate loans are 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 March 31, 2019 and December 31, 2018, the Company’s REO had an aggregate carrying value of $290.6 million and $249.4 million, and an aggregate estimated fair value of $320.0 million and $273.4 million, respectively. The Company classifies fair value measurements of REO as Level 3 in the fair value hierarchy.