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 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.

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, the estimated value of the collateral, expected costs and estimated 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.

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. The Company’s Agency MBS are classified as Level 2 in the fair value hierarchy. During the quarter ended June 30, 2020, the Company sold its remaining holdings of Agency MBS.

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. As of September 30, 2020, the Company has sold substantially all of its holdings of Legacy Non-Agency MBS and substantially reduced its holdings of other Non-Agency MBS and CRT securities.

The Company’s valuation process for term notes backed by MSR-related collateral is similar to that used for residential mortgage securities and considers a number of observable market data points, including prices obtained from pricing services, brokers and repurchase agreement counterparties, dialogue with market participants, as well as management’s observations of market activity. Other factors taken into consideration include 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. Based on its evaluation of the observability of the data used in its fair value estimation process, these assets are classified as Level 2 in the fair value hierarchy.

As previously disclosed, in response to the turmoil in the financial markets resulting from the COVID-19 pandemic experienced during the three months ended March 31, 2020, the Company unwound all of its Swap hedging transactions late in the first quarter in order to recover previously posted margin. Prior to their termination, valuations provided by the central clearing house were used for purposes of determining the fair value of the Company’s Swaps. Such valuations obtained were tested with internally developed models that applied readily observable market parameters. Swaps were classified as Level 2 in the fair value hierarchy.

These agreements are secured and subject to margin calls and their base interest rates reset frequently to market based rates. As a result, no credit valuation adjustment is required, and the primary factor in determining their fair value is the credit spread paid over the base rate, which is a non observable input as it is determined based on negotiations with the counterparty. The Company’s financing agreements with mark-to-market collateral provisions held at fair value are classified as Level 2 in the fair value hierarchy if the credit spreads used to price the instrument reset frequently, which is typically the case with shorter term repurchase agreement contracts collateralized by securities. Financing agreements with mark-to-market collateral provisions that are typically longer term and are collateralized by residential whole loans where the credit spread paid over the base rate on the instrument is not reset frequently are classified as Level 3 in the fair value hierarchy.

These agreements are secured, but not subject to margin calls, and their base interest rates reset frequently to market based rates. As a result, a credit valuation adjustment would only be required if there were a significant decrease in collateral value, and the primary factor in determining their fair value is the credit spread paid over the base rate, which is a non observable input as it is determined based on negotiations with the counterparty. The Company’s financing agreements with non-mark-to-market collateral provisions held at fair value are classified as Level 3 in the fair value hierarchy.

The estimated fair value of the Term Loan Facility was determined by management based on a valuation received from a third party that specializes in providing valuations on financial instruments. The most significant inputs to such valuation, market interest rates and the yield on the Company’s publicly traded financial instruments, are observable. The Company’s Term Loan Facility held at fair value is 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.


(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Residential whole loans, at fair value	$	—	$	—	$	1,229,664	$	1,229,664
Non-Agency MBS	—		56,430		—		56,430
CRT securities	—		96,335		—		96,335
Term notes backed by MSR-related collateral	—		234,091		—		234,091
Total assets carried at fair value	$	—	$	386,856	$	1,229,664	$	1,616,520
Liabilities:
Agreements with non-mark-to-market collateral provisions	$	—	$	—	$	1,727,407	$	1,727,407
Agreements with mark-to-market collateral provisions	—		258,537		1,231,734		1,490,271
Senior secured credit agreement	—		473,993		—		473,993
Securitized debt	—		388,790		—		388,790
Total liabilities carried at fair value	$	—	$	1,121,320	$	2,959,141	$	4,080,461


(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Residential whole loans, at fair value	$	—	$	—	$	1,381,583	$	1,381,583
Non-Agency MBS	—		2,063,529		—		2,063,529
Agency MBS	—		1,664,582		—		1,664,582
CRT securities	—		255,408		—		255,408
Term notes backed by MSR-related collateral	—		1,157,463		—		1,157,463
Total assets carried at fair value	$	—	$	5,140,982	$	1,381,583	$	6,522,565

The following table presents additional information for the three and nine months ended September 30, 2020 and 2019 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 September 30,				Nine Months Ended September 30,
(In Thousands)	2020		2019 (1)		2020		2019 (1)(2)
Balance at beginning of period	$	1,200,981	$	1,438,827	$	1,381,583	$	1,471,263
Purchases (2)	—		85,855		—		210,030

Changes in fair value recorded in Net gain on residential whole loans measured at fair value through earnings	58,863		13,185		(13,683)		33,312
Cash collections, net of liquidation gains/(losses)	(21,721)		(31,212)		(65,934)		(94,821)
Sales and repurchases	(929)		—		(19,460)		(1,216)
Transfer to REO	(7,530)		(53,486)		(52,842)		(165,399)
Balance at end of period	$	1,229,664	$	1,453,169	$	1,229,664	$	1,453,169

(1)Included in the activity presented for the three months ended September 30, 2019 are approximately $87.0 million of residential whole loans held at fair value the Company committed to purchase during the three months ended June 30, 2019, but for which the closing of the purchase transaction occurred during the three months ended September 30, 2019.

(2)Included in the activity presented for the nine months ended September 30, 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 and nine months ended September 30, 2019 about the Company’s investments in term notes backed by MSR-related collateral, which were classified as Level 3 prior to September 30, 2019 and measured at fair value on a recurring basis:


	Term Notes Backed by MSR-Related Collateral
	Three Months Ended September 30,		Nine Months Ended September 30,
(In Thousands)	2019		2019
Balance at beginning of period	$	1,106,026	$	538,499
Purchases	—		573,137

Collection of principal	(3,920)		(12,897)
Changes in unrealized gains	2,024		5,391
Transfer to Level 2	(1,104,130)		(1,104,130)
Balance at end of period	$	—	$	—

The following table presents additional information for the three and nine months ended September 30, 2020 about the Company’s financing agreements with non-mark-to-market collateral provisions, which are classified as Level 3 and measured at fair value on a recurring basis:


	Agreements with Non-mark-to-market Collateral Provisions
	Three Months Ended September 30,		Nine Months Ended September 30,
(In Thousands)	2020		2020
Balance at beginning of period	$	—	$	—
Transfer from Level 2	2,036,597		2,036,597
Payment of principal	(312,638)		(312,638)
Changes in unrealized losses	3,448		3,448
Balance at end of period	$	1,727,407	$	1,727,407

The following table presents additional information for the three and nine months ended September 30, 2020 about the Company’s financing agreements with mark-to-market collateral provisions, which are classified as Level 3 and measured at fair value on a recurring basis:


	Agreements with Mark-to-market Collateral Provisions
	Three Months Ended September 30,		Nine Months Ended September 30,
(In Thousands)	2020		2020
Balance at beginning of period	$	—	$	—
Transfer from Level 2	1,386,592		1,386,592
Payment of principal	(156,032)		(156,032)
Changes in unrealized losses	1,174		1,174
Balance at end of period	$	1,231,734	$	1,231,734

At June 30, 2020, the Company’s financing agreements with non-mark-to-market collateral provisions and the Company’s financing agreements with mark-to-market collateral provisions had just been issued and were therefore classified as Level 2 since their values were based on market transactions. However, market information for similar financings was not available at September 30, 2020 and the Company valued these financing instruments based on unobservable inputs.

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 September 30, 2020 and December 31, 2019:


	September 30, 2020
(Dollars in Thousands)	Fair Value (1)		Valuation Technique	Unobservable Input	Weighted Average (2)			Range

Residential whole loans, at fair value	$	774,427	Discounted cash flow	Discount rate	3.9		%	3.2-8.0%
				Prepayment rate	3.9		%	0.0-9.3%
				Default rate	6.2		%	0.0-30.3%
				Loss severity	12.7		%	0.0-100.0%

	$	454,760	Liquidation model	Discount rate	8.1		%	6.7-50.0%
				Annual change in home prices	1.9		%	(0.3)-5.5%
				Liquidation timeline (in years)	1.8			0.1-4.8
				Current value of underlying properties (3)	$	734		$12-$4,500
Total	$	1,229,187


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

Residential whole loans, at fair value	$	829,842	Discounted cash flow	Discount rate	4.2		%	3.8-8.0%
				Prepayment rate	4.5		%	0.7-18.0%
				Default rate	4.0		%	0.0-23.0%
				Loss severity	12.9		%	0.0-100.0%

	$	551,271	Liquidation model	Discount rate	8.0		%	6.2-50.0%
				Annual change in home prices	3.7		%	2.4-8.0%
				Liquidation timeline (in years)	1.8			0.1-4.5
				Current value of underlying properties (3)	$	684		$10-$4,500
Total	$	1,381,113

Changes in market conditions, as well as changes in the assumptions or methodology used to determine fair value, could result in a significant increase or decrease in the fair value of residential whole loans. Loans valued using a discounted cash flow model are most sensitive to changes in the discount rate assumption, while loans valued using the liquidation model technique are most sensitive to changes in the current value of the underlying properties and the liquidation timeline. Increases in discount rates, default rates, loss severities, or liquidation timelines, either in isolation or collectively, would generally result in a lower fair value measurement, whereas increases in the current or expected value of the underlying properties, in isolation, would result in a higher fair value measurement. In practice, changes in valuation assumptions may not occur in isolation and the changes in any particular assumption may result in changes in other assumptions, which could offset or amplify the impact on the overall valuation.


	September 30, 2020	September 30, 2020				December 31, 2019
	Level in Fair Value Hierarchy	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
(In Thousands)
Financial Assets:
Residential whole loans, at carrying value	3	$	4,387,559	$	4,528,630	$	6,069,370	$	6,248,745
Residential whole loans, at fair value	3	1,229,664		1,229,664		1,381,583		1,381,583
Non-Agency MBS	2	56,430		56,430		2,063,529		2,063,529
Agency MBS	2	—		—		1,664,582		1,664,582
CRT securities	2	96,335		96,335		255,408		255,408
MSR-related assets (1)	2 and 3	252,183		252,183		1,217,002		1,217,002
Cash and cash equivalents	1	884,171		884,171		70,629		70,629
Restricted cash	1	5,303		5,303		64,035		64,035
Financial Liabilities (2):
Financing agreements with non-mark-to-market collateral provisions	3	1,727,407		1,727,407		—		—
Financing agreements with mark-to-market collateral provisions	3	1,231,734		1,231,734		4,741,971		4,753,070
Financing agreements with mark-to-market collateral provisions	2	258,537		258,537		4,397,850		4,403,139
Senior secured credit agreement	2	473,993		473,993		—		—
Securitized debt (3)	2	837,683		839,914		570,952		575,353
Convertible senior notes	2	224,867		216,919		223,971		244,088
Senior notes	1	96,900		94,311		96,862		103,231

The Company holds REO at the lower of the current carrying amount or fair value less estimated selling costs. During the nine months ended September 30, 2020 and 2019, the Company recorded REO with an aggregate estimated fair value, less estimated cost to sell, of $74.9 million and $193.5 million, respectively, at the time of foreclosure. The Company classifies fair value measurements of REO as Level 3 in the fair value hierarchy.