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, (ii) the assessment of observable or reported recent trading activity and (iii) the solicitation of valuations from third parties (typically, broker-dealers). The Manager utilizes such information to assign a good faith fair value (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 seeks to obtain at least one third-party indicative valuation for each instrument, and often obtains multiple indicative valuations when available. 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 assumptions and default rate assumptions. The Manager has been able to obtain third-party valuations on the vast majority of the Company’s assets and expects to continue to solicit third party valuations on substantially all assets in the future to the extent practical. Third-party valuations are not binding on the Manager; rather, the Manager uses its judgment, based on its own models, recent trading activity in the same or similar instruments, and the indicative valuations received from third parties to determine and assign fair values to our Level 3 assets. We believe that third-party valuations play an important role in ensuring that the Manager’s valuation determinations are fair and reasonable. The Manager’s valuation process is overseen by the Manager’s valuation committee. Because of the inherent uncertainty of valuation, these 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 December 31, 2012:



(In thousands)
Description	Level 1			Level 2			Level 3			Total
Assets:
Cash and cash equivalents	$	59,084		$	—		$	—		$	59,084
Investments at fair value-
Agency residential mortgage-backed securities	$	—		$	811,233		$	6,644		$	817,877
Private label residential mortgage-backed securities	—			—			528,366			528,366
Private label commercial mortgage-backed securities	—			—			19,327			19,327
Commercial mortgage loans	—			—			9,546			9,546
Total investments at fair value	—			811,233			563,883			1,375,116
Financial derivatives-assets at fair value-
Credit default swaps on asset-backed securities	—			—			36,031			36,031
Credit default swaps on asset-backed indices	—			12,468			—			12,468
Interest rate swaps	—			5			—			5
Total financial derivatives-assets at fair value	—			12,473			36,031			48,504
Repurchase agreements	—			13,650			—			13,650
Total investments, financial derivatives-assets at fair value, and repurchase agreements	$	—		$	837,356		$	599,914		$	1,437,270
Liabilities:
Investments sold short at fair value-
U.S. Treasury and Agency residential mortgage-backed securities	$	—		$	(622,301	)	$	—		$	(622,301	)
Financial derivatives-liabilities at fair value-
Credit default swaps on corporate indices	—			(484		)	—			(484		)
Credit default swaps on asset-backed indices	—			(13,468		)	—			(13,468		)
Credit default swaps on asset-backed securities	—			—			(1		)	(1		)
Interest rate swaps	—			(1,124		)	—			(1,124		)
Total return swaps	—			(65		)	—			(65		)
Unrealized depreciation on futures contracts	(70		)	—			—			(70		)
Total financial derivatives-liabilities at fair value	(70		)	(15,141		)	(1		)	(15,212		)
Securitized debt	—			—			(1,335		)	(1,335		)
Total investments sold short, financial derivatives-liabilities at fair value, and securitized debt	$	(70	)	$	(637,442	)	$	(1,336	)	$	(638,848	)

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 year ended December 31, 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 December 31, 2012:



	Fair Value as of December 31, 2012		Valuation Technique	Unobservable Input	Range				Weighted Average
Description	Fair Value as of December 31, 2012		Valuation Technique	Unobservable Input	Min		Max		Weighted Average
	(In thousands)
Private label residential mortgage-backed securities⁽¹⁾	$	527,031	Discounted Cash Flows	Yield	2.6	%	29.1	%	7.8	%
				Projected Collateral Prepayments	0.7	%	64.6	%	22.7	%
				Projected Collateral Losses	3.7	%	79.7	%	28.0	%
				Projected Collateral Recoveries	0.0	%	41.0	%	21.4	%
				Projected Collateral Scheduled Amortization	4.1	%	90.4	%	27.9	%
									100.0	%
Credit default swaps on asset-backed securities	36,030		Net Discounted Cash Flows	Projected Collateral Prepayments	8.7	%	44.1	%	18.7	%
				Projected Collateral Losses	20.4	%	57.1	%	37.8	%
				Projected Collateral Recoveries	12.2	%	32.8	%	19.3	%
				Projected Collateral Scheduled Amortization	9.8	%	35.5	%	24.2	%
									100.0	%
Private label commercial mortgage-backed securities and Commercial mortgage loans	28,873		Discounted Cash Flows	Yield	5.2	%	17.9	%	9.5	%
				Projected Collateral Losses	0.0	%	25.1	%	3.9	%
				Projected Collateral Recoveries	0.0	%	88.9	%	20.5	%
				Projected Collateral Scheduled Amortization	0.0	%	100.0	%	75.6	%
									100.0	%
Agency interest only residential mortgage-backed securities	6,644		Option Adjusted Spread (“OAS”)	LIBOR OAS ⁽²⁾	816		7,558		1,189
				Projected Collateral Prepayments	81.0	%	100.0	%	92.7	%
				Projected Collateral Scheduled Amortization⁽³⁾	0.0	%	19.0	%	7.3	%
									100.0	%


(1)	Includes securitized debt with a fair value of $1.3 million as of December 31, 2012.


(2)	Shown in basis points.


(3)	For simplicity of presentation, net negative amortization is disregarded.

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 be accompanied by a lower expectation of collateral losses. Conversely, higher losses will generally be accompanied by 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	$	—		$	—	$	62,737
Investments at fair value-
U.S. Treasury and Agency residential mortgage-backed securities	$	—	$	769,120		$	5,337	$	774,457
Private label residential mortgage-backed securities	—		—			417,533		417,533
Private label commercial mortgage-backed securities	—		—			16,093		16,093
Commercial mortgage loans	—		—			4,400		4,400
Total investments at fair value	—		769,120			443,363		1,212,483
Financial derivatives-assets at fair value-
Credit default swaps on corporate indices	—		963			—		963
Credit default swaps on asset-backed securities	—		—			61,498		61,498
Credit default swaps on asset-backed indices	—		40,303			—		40,303
Interest rate swaps	—		95			—		95
Unrealized appreciation on futures contracts	12		—			—		12
Total financial derivatives-assets at fair value	12		41,361			61,498		102,871
Repurchase agreements	—		15,750			—		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	$	—	$	(462,394	)	$	—	$	(462,394	)
Financial derivatives-liabilities at fair value-
Credit default swaps on asset-backed indices	—		(9,548		)	—		(9,548		)
Total return swaps	—		(274		)	—		(274		)
Interest rate swaps	—		(17,218		)	—		(17,218		)
Total financial derivatives-liabilities at fair value	—		(27,040		)	—		(27,040		)
Total investments sold short and financial derivatives-liabilities at fair value	$	—	$	(489,434	)	$	—	$	(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 year ended December 31, 2012, 2011, and 2010 (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:

Year Ended December 31, 2012



(In thousands)	Beginning Balance as of December 31, 2011		Accreted Discounts / (Amortized Premiums)			Net Realized Gain/ (Loss)			Change in Net Unrealized Gain/(Loss)			Purchases/ Payments		Sales/ Issuances			Transfers In and/or Out of Level 3		Ending Balance as of December 31, 2012
Assets:
Investments at fair value-
U.S. Treasury and Agency residential mortgage-backed securities	$	5,337	$	(2,277	)	$	111		$	(568	)	$	5,201	$	(1,160	)	$	—	$	6,644
Private label residential mortgage-backed securities	417,533		21,896			15,657			69,286			323,554		(319,560		)	—		528,366
Private label commercial mortgage-backed securities	16,093		570			7,619			(255		)	110,752		(115,452		)	—		19,327
Commercial mortgage loans	4,400		87			—			413			4,646		—			—		9,546
Total investments at fair value	443,363		20,276			23,387			68,876			444,153		(436,172		)	—		563,883
Financial derivatives- assets at fair value-
Credit default swaps on asset-backed securities	61,498		—			(1,164		)	3,218			10,840		(38,361		)	—		36,031
Total financial derivatives- assets at fair value	61,498		—			(1,164		)	3,218			10,840		(38,361		)	—		36,031
Total investments and financial derivatives-assets at fair value	$	504,861	$	20,276		$	22,223		$	72,094		$	454,993	$	(474,533	)	$	—	$	599,914
Liabilities:
Financial derivatives- liabilities at fair value-
Credit default swaps on asset-backed securities	$	—	$	—		$	(79	)	$	(1	)	$	—	$	79		$	—	$	(1	)
Total financial derivatives- liabilities at fair value	$	—	$	—		$	(79	)	$	(1	)	$	—	$	79		$	—	$	(1	)
Securitized Debt:
Securitized debt	$	—	$	(55	)	$	—		$	(23	)	$	265	$	(1,522	)	$	—	$	(1,335	)
Total securitized debt	$	—	$	(55	)	$	—		$	(23	)	$	265	$	(1,522	)	$	—	$	(1,335	)
Total financial derivatives- liabilities at fair value and securitized debt	$	—	$	(55	)	$	(79	)	$	(24	)	$	265	$	(1,443	)	$	—	$	(1,336	)

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 December 31, 2012, as well as Level 3 financial instruments disposed of by the Company during the year ended December 31, 2012. For Level 3 financial instruments held by the Company at December 31, 2012, change in net unrealized gain (loss) of $52.4 million, $(10.8) million, $(1.0) thousand, and $(0.02) million, for the year ended December 31, 2012 relate to investments, financial derivatives–assets, financial derivatives–liabilities, and securitized debt, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Year Ended December 30, 2011



(In thousands)	Beginning Balance as of December 31, 2010		Accreted Discounts / (Amortized Premiums)			Net Realized Gain/ (Loss)		Change in Net Unrealized Gain/(Loss)			Purchases		Sales			Transfers In and/or Out of Level 3		Ending Balance as of December 31, 2011
Assets:
Investments at fair value-
Agency residential mortgage-backed securities	$	—	$	(1,457	)	$	97	$	(2,078	)	$	9,930	$	(1,155	)	$	—	$	5,337
Private label residential mortgage-backed securities	338,839		16,259			17,246		(43,559		)	342,360		(253,612		)	—		417,533
Private label commercial mortgage-backed securities	1,850		539			1,121		(2,987		)	27,564		(11,994		)	—		16,093
Commercial mortgage loans	—		114			—		(389		)	4,675		—			—		4,400
Total investments at fair value	340,689		15,455			18,464		(49,013		)	384,529		(266,761		)	—		443,363
Financial derivatives- assets at fair value -
Credit default swaps on asset-backed securities	102,850		—			9,969		(5,721		)	5,942		(51,542		)	—		61,498
Total financial derivatives- assets at fair value	102,850		—			9,969		(5,721		)	5,942		(51,542		)	—		61,498
Total investments and financial derivatives- assets at fair value	$	443,539	$	15,455		$	28,433	$	(54,734	)	$	390,471	$	(318,303	)	$	—	$	504,861

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 December 31, 2011, as well as Level 3 financial instruments disposed of by the Company during the year ended December 31, 2011. For Level 3 financial instruments held by the Company at December 31, 2011, change in net unrealized gain (loss) of $(39.6) million and $(14.2) million for the year ended December 31, 2011 relate to investments and financial derivatives–assets, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Year Ended December 31, 2010



(In thousands)	Beginning Balance as of December 31, 2009			Accreted Discounts / (Amortized Premiums)			Net Realized Gain/ (Loss)			Change in Net Unrealized Gain/(Loss)			Purchases		Sales			Transfers In and/or Out of Level 3		Ending Balance as of December 31, 2010
Assets:
Investments at fair value-
Private label residential mortgage-backed securities	$	210,364		$	11,632		$	22,933		$	20,083		$	324,286	$	(250,459	)	$	—	$	338,839
Private label commercial mortgage-backed securities	—			(13		)	—			13			1,850		—			—		1,850
Total investments at fair value	210,364			11,619			22,933			20,096			326,136		(250,459		)	—		340,689
Financial derivatives- assets at fair value -
Credit default swaps on corporate bonds	8,476			—			(2,281		)	(2,650		)	1,713		(5,258		)	—		—
Credit default swaps on asset-backed securities	95,199			—			11,415			(20,085		)	45,369		(29,048		)	—		102,850
Other swaps	257			—			335			(257		)	—		(335		)	—		—
Total financial derivatives- assets at fair value	103,932			—			9,469			(22,992		)	47,082		(34,641		)	—		102,850
Total investments and financial derivatives-assets at fair value	$	314,296		$	11,619		$	32,402		$	(2,896	)	$	373,218	$	(285,100	)	$	—	$	443,539
Liabilities:
Financial derivatives-liabilities at fair value
Credit default swaps on asset-backed securities	$	(10,548	)	$	—		$	(1,657	)	$	3,881		$	8,324	$	—		$	—	$	—
Total financial derivatives-liabilities at fair value	$	(10,548	)	$	—		$	(1,657	)	$	3,881		$	8,324	$	—		$	—	$	—

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 December 31, 2010, as well as Level 3 financial instruments disposed of by the Company during the year ended December 31, 2010. For Level 3 financial instruments held by the Company at December 31, 2010, change in net unrealized gain (loss) of $18.9 million and $(21.0) million for the year ended December 31, 2010 relate to investments and financial derivatives–assets, respectively.