Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2012

Fair Value of Financial Instruments

Fair Value of Financial Instruments

14.  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, 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.

Agency MBS, Non-Agency MBS and Securitized Debt

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

Linked Transactions

The Non-Agency MBS underlying the Company’s Linked Transactions are valued using similar techniques to those used for the Company’s other Non-Agency MBS.  The value of the underlying MBS is 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 includes accrued interest receivable on the MBS and accrued interest payable on the underlying repurchase agreement borrowings.  The Company’s Linked Transactions are classified as Level 2 in the fair value hierarchy.

Derivative Hedging Instruments (Swaps)

The Company determines the fair value of its derivative hedging instruments considering valuations obtained from a third-party pricing service and such valuations are tested with internally developed models that apply readily observable market parameters.  In valuing its derivative hedging instruments, 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 derivative hedging instruments are subject to bilateral collateral arrangements.  Consequently, no credit valuation adjustment was made in determining the fair value of such instruments.  The Company’s derivative hedging instruments are classified as Level 2 in the fair value hierarchy.

The following table presents the Company’s financial instruments carried at fair value as of September 30, 2012, on the consolidated balance sheet by the valuation hierarchy, as previously described:

Fair Value at September 30, 2012
(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Agency MBS	$	—	$	7,476,848	$	—	$	7,476,848
Non-Agency MBS, including MBS transferred to consolidated VIEs	—		5,196,975		—		5,196,975
Securities obtained and pledged as collateral	509,704		—		—		509,704
Linked Transactions	—		12,767		—		12,767
Total assets carried at fair value	$	509,704	$	12,686,590	$	—	$	13,196,294
Liabilities:
Derivative hedging instruments	$	—	$	78,169	$	—	$	78,169
Obligation to return securities obtained as collateral	509,704		—		—		509,704
Total liabilities carried at fair value	$	509,704	$	78,169	$	—	$	587,873

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.  As markets and products develop and the pricing for certain products becomes more transparent, the Company continues to refine its valuation methodologies.  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, which could cause its financial instruments to be reclassified to a different level.

The following table presents the carrying value and estimated fair value of the Company’s financial instruments, at September 30, 2012 and December 31, 2011:

	September 30, 2012				December 31, 2011
	Carrying		Estimated		Carrying		Estimated
(In Thousands)	Value		Fair Value		Value		Fair Value
Financial Assets:
Agency MBS	$	7,476,848	$	7,476,848	$	7,137,531	$	7,137,531
Non-Agency MBS, including MBS transferred to consolidated VIEs	5,196,975		5,196,975		3,775,446		3,775,446
Securities obtained and pledged as collateral	509,704		509,704		306,401		306,401
Cash and cash equivalents	450,442		450,442		394,022		394,022
Restricted cash	7,013		7,013		15,502		15,502
Linked Transactions	12,767		12,767		55,801		55,801
Derivative hedging instruments	—		—		26		26
Financial Liabilities:
Repurchase agreements	8,832,326		8,832,751		7,813,159		7,812,652
Securitized debt	749,471		749,022		875,520		859,506
Obligation to return securities obtained as collateral	509,704		509,704		306,401		306,401
Senior Notes	100,000		103,920		—		—
Derivative hedging instruments	78,169		78,169		114,220		114,220

In addition to the methodologies used to determine the fair value of the Company’s financial assets and liabilities reported at fair value, 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:

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 September 30, 2012 and December 31, 2011, 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.

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.

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.