3. Valuation

The following is a description of the valuation methodologies used for the Company's financial instruments.

Level 1 valuation methodologies include the observation of quoted prices (unadjusted) for identical assets or liabilities in active markets, often received from widely recognized data providers.

Level 2 valuation methodologies include the observation of (i) quoted prices for similar assets or liabilities in active markets, (ii) inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves) in active markets and (iii) quoted prices for identical or similar assets or liabilities in markets that are not active.

Level 3 valuation methodologies include (i) the use of proprietary models that require the use of a significant amount of judgment and the application of various assumptions including, but not limited to, prepayment and default rate assumptions and (ii) the solicitation of valuations from third parties (typically, broker-dealers). Third-party valuation providers often utilize proprietary models that are highly subjective and also require the use of a significant amount of judgment and the application of various assumptions including, but not limited to, prepayment and default rate assumptions. The Manager utilizes such information to assign a good faith valuation (the estimated price that would be received to sell an asset or paid to transfer a liability in an orderly transaction at the valuation date) to such financial instruments. The Manager has been able to obtain third-party valuations on the vast majority of the Company's financial instruments and expects to continue to solicit third-party valuations on substantially all of the Company's financial instruments in the future to the extent practical.

The Manager uses its judgment based on its own models, the assessments of its portfolio managers, and third-party valuations it obtains, to determine and assign fair values to the Company's Level 3 financial instruments. Because of the inherent uncertainty of valuation, estimated values may differ significantly from the values that would have been used had a ready market for the financial instruments existed and the differences could be material to the consolidated financial statements.

The table below reflects the value of the Company's Level 1, Level 2 and Level 3 financial instruments at September 30, 2012:


(In thousands)
Description		Level 1			Level 2			Level 3			Total
Assets:
Cash and cash equivalents	$	69,223		$	0		$	0		$	69,223
Investments at fair value-
Agency residential mortgage-backed securities	$	0		$	650,046		$	3,827		$	653,873
Private label residential mortgage-backed
securities		0			0			457,925			457,925
Private label commercial mortgage-backed
securities		0			0			49,196			49,196
Commercial mortgage loans		0			0			4,650			4,650
Total investments at fair value		0			650,046			515,598			1,165,644
Financial derivatives-assets at fair value-
Credit default swaps on asset-backed securities		0			0			31,460			31,460
Credit default swaps on asset-backed indices		0			27,113			0			27,113
Total return swaps		0			257			0			257
Interest rate swaps		0			512			0			512
Total financial derivatives-assets at fair value		0			27,882			31,460			59,342
Repurchase agreements		0			13,780			0			13,780
Total investments, financial derivatives-assets
at fair value and repurchase agreements	$	0		$	691,708		$	547,058		$	1,238,766

Liabilities:
Investments sold short at fair value-
U.S. Treasury and Agency residential
mortgage-backed securities	$	0		$	(456,824	)	$	0		$	(456,824	)
Financial derivatives-liabilities at fair value-
Credit default swaps on corporate indices		0			(276	)		0			(276	)
Credit default swaps on asset-backed indices		0			(17,676	)		0			(17,676	)
Interest rate swaps		0			(2,126	)		0			(2,126	)
Unrealized depreciation on futures contracts		(87	)		0			0			(87	)
Total financial derivatives-liabilities at fair value		(87	)		(20,078	)		0			(20,165	)
Securitized debt		0			0			(1,439	)		(1,439	)
Total investments sold short, financial derivatives-
liabilities at fair value and securitized debt	$	(87	)	$	(476,902	)	$	(1,439	)	$	(478,428	)

Investments under the Agency residential mortgage-backed securities Level 3 category are investments in Agency interest only RMBS securities. There were no transfers of financial instruments between Level 1, Level 2 or Level 3 during the nine month period ended September 30, 2012.

The Company's reverse repurchase agreements are carried at cost, which approximates fair value. These liabilities are classified as Level 2 liabilities based on the adequacy of the collateral and their short term nature.

The following table identifies the significant unobservable inputs that affect the valuation of the Company's Level 3 assets and liabilities as of September 30, 2012:


					Range
		Fair Value as of
		September 30,	Valuation						Weighted
Description		2012	Technique	Unobservable Input	Min		Max		Average
		(In thousands)
Private label residential mortgage-backed securities ⁽¹⁾	$	456,486	Discounted Cash Flows	Yield	2.5	%	56.3	%	9.4	%
				Projected Collateral Prepayments	0.6	%	47.0	%	17.7	%
				Projected Collateral Losses	3.7	%	87.5	%	35.0	%
				Projected Collateral Recoveries	0.0	%	39.5	%	19.7	%
				Projected Collateral Scheduled Amortization	3.5	%	90.3	%	27.6	%
									100.0	%

Credit default swaps on asset-backed securities		31,460	Net Discounted Cash Flows	Projected Collateral Prepayments	5.6	%	37.1	%	15.2	%
				Projected Collateral Losses	25.0	%	62.8	%	43.1	%
				Projected Collateral Recoveries	10.0	%	39.3	%	18.9	%
				Projected Collateral Scheduled Amortization	8.0	%	37.1	%	22.8	%
									100.0	%

Private label commercial mortgage-backed securities and Commercial mortgage loans		53,846	Discounted Cash Flows	Yield	0.8	%	13.2	%	7.9	%
				Projected Collateral Losses	0.0	%	40.1	%	1.8	%
				Projected Collateral Recoveries	0.0	%	23.6	%	2.3	%
				Projected Collateral Scheduled Amortization	60.0	%	100.0	%	95.9	%
									100.0	%

Agency interest only residential mortgage-backed securities		3,827	Option Adjusted Spread ("OAS")	LIBOR OAS⁽²⁾	526		1,662		1,055
				Projected Collateral Prepayments	84.0	%	96.2	%	89.3	%
				Projected Collateral Scheduled Amortization	3.8	%	16.0	%	10.7	%
									100.0	%

⁽¹⁾Includes securitized debt with a fair value of $1.4 million as of September 30, 2012.

⁽²⁾Shown in basis points.

Collateral prepayments, losses, recoveries and scheduled amortization are projected over the remaining life of the collateral and expressed as a percentage of the collateral's current principal balance. Averages are weighted based on the fair value of the related instrument. In the case of credit default swaps on asset-backed securities, averages are weighted based on each instrument's bond equivalent value. Bond equivalent value represents the investment amount of a corresponding position in the reference obligation, calculated as the difference between the outstanding principal balance of the underlying reference obligation and the fair value, inclusive of accrued interest, of the derivative contract. The Company uses a LIBOR Option Adjusted Spread ("OAS") valuation methodology to value its Agency interest only RMBS assets. In the LIBOR OAS methodology, cash flows are projected using Ellington's models over multiple interest rate scenarios, and these projected cash flows are then discounted using the LIBOR rates implied by each interest rate scenario. The LIBOR OAS of an asset is then computed as the unique constant yield spread that, when added to all LIBOR rates in each interest rate scenario generated by the model, will equate (a) the expected present value of the projected asset cash flows over all model scenarios to (b) the actual current market price of the asset. LIBOR OAS is therefore model-dependent. Generally speaking, LIBOR OAS measures the additional yield spread over LIBOR that an asset provides at its current market price after taking into account any interest rate options embedded in the asset.

Material changes in any of the inputs above in isolation could result in a significant change to reported fair value measurements. Additionally, fair value measurements are impacted by the interrelationships of these inputs. For example, a higher expectation of collateral prepayments will generally result in a lower expectation of collateral losses. Conversely, higher losses will generally result in lower prepayments. Because the Company's credit default swaps on asset-backed security holdings represent credit default swap contracts whereby the Company has purchased credit protection, such default swaps on asset-backed securities generally have the directionally opposite sensitivity to prepayments, losses and recoveries as compared to the Company's long securities holdings. Prepayments do not represent a significant input for the Company's commercial mortgage-backed securities and commercial mortgage loans. Losses and recoveries do not represent a significant input for the Company's Agency RMBS interest only securities, given the guarantee of the issuing government agency or government-sponsored enterprise.

The table below reflects the value of the Company's Level 1, Level 2 and Level 3 financial instruments at December 31, 2011:


(In thousands)
Description		Level 1		Level 2			Level 3		Total
Assets:
Cash and cash equivalents	$	62,737	$	0		$	0	$	62,737
Investments at fair value-
U.S. Treasury and Agency residential
mortgage-backed securities	$	0	$	769,120		$	5,337	$	774,457
Private label residential mortgage-backed
securities		0		0			417,533		417,533
Private label commercial mortgage-backed
securities		0		0			16,093		16,093
Commercial mortgage loans		0		0			4,400		4,400
Total investments at fair value		0		769,120			443,363		1,212,483
Financial derivatives-assets at fair value-
Credit default swaps on corporate indices		0		963			0		963
Credit default swaps on asset-backed securities		0		0			61,498		61,498
Credit default swaps on asset-backed indices		0		40,303			0		40,303
Interest rate swaps		0		95			0		95
Unrealized appreciation on futures contracts		12		0			0		12
Total financial derivatives-assets at fair value		12		41,361			61,498		102,871
Repurchase agreements		0		15,750			0		15,750
Total investments, financial derivatives-assets
at fair value and repurchase agreements	$	12	$	826,231		$	504,861	$	1,331,104

Liabilities:
Investments sold short at fair value-
U.S. Treasury and Agency residential
mortgage-backed securities	$	0	$	(462,394	)	$	0	$	(462,394	)
Financial derivatives-liabilities at fair value-
Credit default swaps on asset-backed indices		0		(9,548	)		0		(9,548	)
Total return swaps		0		(274	)		0		(274	)
Interest rate swaps		0		(17,218	)		0		(17,218	)
Total financial derivatives-liabilities at fair value		0		(27,040	)		0		(27,040	)
Total investments sold short and financial
derivatives-liabilities at fair value	$	0	$	(489,434	)	$	0	$	(489,434	)

Investments under the U.S. Treasury and Agency residential mortgage-backed securities Level 3 category are investments in Agency interest only RMBS securities. There were no transfers of financial instruments between Level 1, Level 2 or Level 3 during the year ended December 31, 2011.

The tables below include a roll-forward of the Company's financial instruments for the three and nine month periods ended September 30, 2012 and 2011 (including the change in fair value), for financial instruments classified by the Company within Level 3 of the valuation hierarchy.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Three Month Period Ended September 30, 2012


		Beginning			Accreted					Change in								Transfers		Ending
		Balance as of			Discounts /					Net								In and/or	Balance as of
		June 30,			(Amortized			Realized		Unrealized								Out of Level		September
(In thousands)		2012			Premiums)			Gain/(Loss)		Gain/(Loss)			Purchases/Payments		Sales/Issuances			3		30, 2012
Assets:
Investments at fair value-
U.S. Treasury and Agency residential
mortgage-backed securities	$	4,667		$	(534	)	$	111	$	(314	)	$	1,057	$	(1,160	)	$	0	$	3,827
Private label residential
mortgage-backed securities		385,059			6,182			5,440		24,013			92,412		(55,181	)		0		457,925
Private label commercial
mortgage-backed securities		28,405			271			2,905		(293	)		57,195		(39,287	)		0		49,196
Commercial mortgage loans		4,650			21			0		(21	)		0		0			0		4,650
Total investments at fair value		422,781			5,940			8,456		23,385			150,664		(95,628	)		0		515,598

Financial derivatives- assets at fair value -
Credit default swaps on asset-backed
securities		38,759			0			3,963		(3,823	)		105		(7,544	)		0		31,460
Total financial derivatives- assets at fair value		38,759			0			3,963		(3,823	)		105		(7,544	)		0		31,460

Total investments and financial derivatives-
assets at fair value	$	461,540		$	5,940		$	12,419	$	19,562		$	150,769	$	(103,172	)	$	0	$	547,058

Liabilities:
Securitized debt	$	(1,415	)	$	(15	)	$	0	$	(51	)	$	42	$	0		$	0	$	(1,439	)
Total securitized debt	$	(1,415	)	$	(15	)	$	0	$	(51	)	$	42	$	0		$	0	$	(1,439	)

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. The table above incorporates changes in net unrealized gain (loss) for both Level 3 financial instruments held by the Company at September 30, 2012, as well as Level 3 financial instruments disposed of by the Company during the three month period ended September 30, 2012. For Level 3 financial instruments held by the Company at September 30, 2012, change in net unrealized gain (loss) of $23.3 million, $(3.8) million and $(0.05) million, for the three month period ended September 30, 2012 relate to investments, financial derivative-assets and securitized debt, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Three Month Period Ended September 30, 2011


		Beginning		Accreted						Change in								Transfers		Ending
		Balance as of		Discounts /						Net								In and/or		Balance as of
		June 30,		(Amortized			Realized			Unrealized								Out of		September 30,
(In thousands)		2011		Premiums)			Gain/(Loss)			Gain/(Loss)			Purchases		Sales			Level 3		2011
Assets:
Investments at fair value-
Agency residential mortgage-backed
securities	$	5,227	$	(423	)	$	0		$	(2,169	)	$	2,826	$	0		$	0	$	5,461
Private label residential
mortgage-backed securities		357,894		4,389			3,107			(12,994	)		106,262		(62,394	)		0		396,264
Private label commercial
mortgage-backed securities		10,942		147			(38	)		(1,707	)		6,918		(1,383	)		0		14,879
Commercial mortgage loans		4,650		31			0			(306	)		0		0			0		4,375
Total investments at fair value		378,713		4,144			3,069			(17,176	)		116,006		(63,777	)		0		420,979

Financial derivatives- assets at fair value -
Credit default swaps on asset-backed
securities		69,829		0			3,088			(248	)		122		(12,885	)		0		59,906
Total financial derivatives- assets at fair value		69,829		0			3,088			(248	)		122		(12,885	)		0		59,906

Total investments and financial derivatives-
assets at fair value	$	448,542	$	4,144		$	6,157		$	(17,424	)	$	116,128	$	(76,662	)	$	0	$	480,885

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. The table above incorporates changes in net unrealized gain (loss) for both Level 3 financial instruments held by the Company at September 30, 2011, as well as Level 3 financial instruments disposed of by the Company during the three month period ended September 30, 2011. For Level 3 financial instruments held by the Company at September 30, 2011, change in net unrealized gain (loss) of $(15.9) million and $2.3 million for the three month period ended September 30, 2011 relate to investments and financial derivative-assets, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Nine Month Period Ended September 30, 2012


		Beginning		Accreted							Change in								Transfers		Ending
		Balance as of		Discounts /							Net								In and/or		Balance as of
		December 31,		(Amortized				Realized			Unrealized								Out of		September
(In thousands)		2011		Premiums)				Gain/(Loss)			Gain/(Loss)			Purchases/Payments		Sales/Issuances			Level 3		30, 2012
Assets:
Investments at fair value-
U.S. Treasury and Agency residential
mortgage-backed securities	$	5,337	$	(1,711	)	$		111		$	(679	)	$	1,929	$	(1,160	)	$	0	$	3,827
Private label residential
mortgage-backed securities		417,533		15,471				12,489			49,149			251,030		(287,747	)		0		457,925
Private label commercial
mortgage-backed securities		16,093		527				3,213			990			79,911		(51,538	)		0		49,196
Commercial mortgage loans		4,400		71				0			179			0		0			0		4,650
Total investments at fair value		443,363		14,358				15,813			49,639			332,870		(340,445	)		0		515,598

Financial derivatives- assets at fair value -
Credit default swaps on asset-
backed securities		61,498		0				(1,514	)		4,285			330		(33,139	)		0		31,460
Total financial derivatives- assets at fair value		61,498		0				(1,514	)		4,285			330		(33,139	)		0		31,460

Total investments and financial
derivatives-assets at fair value	$	504,861	$	14,358		$		14,299		$	53,924		$	333,200	$	(373,584	)	$	0	$	547,058

Liabilities:
Securitized debt	$	0	$	(44	)		$	0		$	(30	)	$	157	$	(1,522	)	$	0	$	(1,439	)
Total Securitized debt	$	0	$	(44	)		$	0		$	(30	)	$	157	$	(1,522	)	$	0	$	(1,439	)

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. The table above incorporates changes in net unrealized gain (loss) for both Level 3 financial instruments held by the Company at September 30, 2012, as well as Level 3 financial instruments disposed of by the Company during the nine month period ended September 30, 2012. For Level 3 financial instruments held by the Company at September 30, 2012, change in net unrealized gain (loss) of $33.7 million, $(8.1) million and $(0.03) million, for the nine month period ended September 30, 2012 relate to investments, financial derivative-assets and securitized debt, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Nine Month Period Ended September 30, 2011


		Beginning		Accreted					Change in								Transfers		Ending
		Balance as of		Discounts /					Net								In and/or		Balance as of
		December 31,		(Amortized			Realized		Unrealized								Out of		September
(In thousands)		2010		Premiums)			Gain/(Loss)		Gain/(Loss)			Purchases		Sales			Level 3		30, 2011
Assets:
Investments at fair value-
Agency residential
mortgage-backed securities	$	0	$	(843	)	$	97	$	(2,320	)	$	9,682	$	(1,155	)	$	0	$	5,461
Private label residential
mortgage-backed securities		338,839		11,710			17,664		(35,632	)		292,521		(228,838	)		0		396,264
Private label commercial
mortgage-backed securities		1,850		378			859		(3,185	)		23,669		(8,692	)		0		14,879
Commercial mortgage loans		0		92			0		(392	)		4,675		0			0		4,375
Total investments at fair value		340,689		11,337			18,620		(41,529	)		330,547		(238,685	)		0		420,979

Financial derivatives- assets at fair value -
Credit default swaps on asset-backed
securities		102,850		0			8,396		(4,987	)		526		(46,879	)		0		59,906
Total financial derivatives- assets at fair value		102,850		0			8,396		(4,987	)		526		(46,879	)		0		59,906

Total investments and financial
derivatives-assets at fair value	$	443,539	$	11,337		$	27,016	$	(46,516	)	$	331,073	$	(285,564	)	$	0	$	480,885

All amounts of net realized and change in net unrealized gain (loss) in the table above are reflected in the accompanying Consolidated Statement of Operations. The table above incorporates changes in net unrealized gain (loss) for both Level 3 financial instruments held by the Company at September 30, 2011, as well as Level 3 financial instruments disposed of by the Company during the nine month period ended September 30, 2011. For Level 3 financial instruments held by the Company at September 30, 2011, change in net unrealized loss of $32.2 million and $12.6 million for the nine month period ended September 30, 2011 relate to investments and financial derivative-assets, respectively.