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 solicitation of valuations from third parties (typically, broker-dealers), (ii)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 assumptions and default rate assumptions, and (iii) the assessment of observable or reported recent trading activity. The Company 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 each such financial instrument.

The Company 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 Company 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. Beginning January 1, 2013, the Company generally values each financial instrument at the average of third-party valuations received and not rejected as described below. Third-party valuations are not binding on the Company and while the Company generally does not adjust valuations it receives, the Company may challenge or reject a valuation when, based on validation criteria, the Company determines that such valuation is unreasonable or erroneous. Furthermore, the Company may determine, based on validation criteria, that for a given instrument the average of the third-party valuations received does not result in what the Company believes to be fair value, and in such circumstances the Company may override this average with its own good faith valuation. The validation criteria include the use of the Company's own models, recent trading activity in the same or similar instruments, and valuations received from third parties. Prior to 2013, the valuation process relied more heavily on the use of the Company's models and observation of reported recent trading activity, which was substantiated by third-party valuations. The Company's valuation process, including the application of validation criteria, 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 September 30, 2013:



(In thousands)
Description	Level 1			Level 2			Level 3			Total
Assets:
Cash and cash equivalents	$	186,737		$	—		$	—		$	186,737
Investments at fair value-
Agency residential mortgage-backed securities	$	—		$	1,069,274		$	37,033		$	1,106,307
Private label residential mortgage-backed securities	—			—			651,982			651,982
Private label commercial mortgage-backed securities	—			—			33,271			33,271
Commercial mortgage loans	—			—			14,936			14,936
Other asset-backed securities	—			—			45,255			45,255
Total investments at fair value	—			1,069,274			782,477			1,851,751
Financial derivatives-assets at fair value-
Credit default swaps on asset-backed securities	—			—			17,615			17,615
Credit default swaps on asset-backed indices	—			9,184			—			9,184
Interest rate swaps	—			15,773			—			15,773
Total return swaps	—			15			—			15
Options	—			4			—			4
Futures	976			—			—			976
Total financial derivatives-assets at fair value	976			24,976			17,615			43,567
Repurchase agreements	—			40,994			—			40,994
Total investments, financial derivatives-assets at fair value, and repurchase agreements	$	976		$	1,135,244		$	800,092		$	1,936,312
Liabilities:
Investments sold short at fair value-
U.S. Treasury and Agency residential mortgage-backed securities	$	—		$	(860,128	)	$	—		$	(860,128	)
Financial derivatives-liabilities at fair value-
Credit default swaps on corporate indices	—			(9,679		)	—			(9,679		)
Credit default swaps on asset-backed indices	—			(19,310		)	—			(19,310		)
Credit default swaps on asset-backed securities	—			—			(319		)	(319		)
Interest rate swaps	—			(4,122		)	—			(4,122		)
Total return swaps	—			(22		)	—			(22		)
Options	—			(4		)	—			(4		)
Futures	(1		)	—			—			(1		)
Total financial derivatives-liabilities at fair value	(1		)	(33,137		)	(319		)	(33,457		)
Securitized debt	—			—			(1,038		)	(1,038		)
Total investments sold short, financial derivatives-liabilities at fair value, and securitized debt	$	(1	)	$	(893,265	)	$	(1,357	)	$	(894,623	)

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 three or nine month periods ended September 30, 2013.

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, 2013:



	Fair Value		Valuation Technique	Unobservable Input	Range						Weighted Average
Description	Fair Value		Valuation Technique	Unobservable Input	Min			Max			Weighted Average
	(In thousands)
Private label residential mortgage-backed securities and Other asset-backed securities⁽¹⁾	$	618,124	Market Quotes	Non Binding Indicative Price	$	1.80		$	145.25		$	79.48
Private label residential mortgage-backed securities	78,075		Discounted Cash Flows	Yield	5.8		%	21.7		%	7.8		%
				Projected Collateral Prepayments	6.2		%	64.6		%	34.4		%
				Projected Collateral Losses	1.8		%	44.6		%	18.8		%
				Projected Collateral Recoveries	0.2		%	19.6		%	10.8		%
				Projected Collateral Scheduled Amortization	13.5		%	88.5		%	36.0		%
											100.0		%
Credit default swaps on asset-backed securities	17,296		Net Discounted Cash Flows	Projected Collateral Prepayments	19.2		%	57.0		%	28.5		%
				Projected Collateral Losses	17.1		%	49.4		%	36.8		%
				Projected Collateral Recoveries	8.0		%	15.4		%	13.1		%
				Projected Collateral Scheduled Amortization	16.0		%	40.5		%	21.6		%
											100.0		%
Private label commercial mortgage-backed securities and Performing commercial mortgage loans	38,221		Market Quotes	Non Binding Indicative Price	$	15.13		$	100.33		$	73.84
Non-performing commercial mortgage loans	9,986		Discounted Cash Flows	Yield	15.0		%	15.0		%	15.0		%
				Months to Resolution	8			10			9
Agency interest only residential mortgage-backed securities	32,385		Market Quotes	Non Binding Indicative Price	$	6.42		$	29.63		$	14.59
Agency interest only residential mortgage-backed securities	4,648		Option Adjusted Spread ("OAS")	LIBOR OAS⁽²⁾	408			649			619
				Projected Collateral Prepayments	76.8		%	100.0		%	92.4		%
				Projected Collateral Scheduled Amortization	0.0		%	23.2		%	7.6		%
											100.0		%


(1)	Includes securitized debt with a fair value of $1.0 million as of September 30, 2013.


(2)	Shown in basis points.

Third-party non-binding indicative prices are validated by comparing such prices to internally generated prices based on the Company's models and to recent trading activity in the same or similar instruments.

For those instruments valued using discounted and net discounted cash flows, 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. For those assets valued using the LIBOR Option Adjusted Spread ("OAS") valuation methodology, cash flows are projected using the Company'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. The Company considers the expected timeline to resolution in the determination of fair value for its non-performing commercial loans.

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, 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		)
Futures	(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 and financial derivatives-liabilities at fair value	$	(70	)	$	(637,442	)	$	(1,336	)	$	(638,848	)

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		Valuation Technique	Unobservable Input	Range				Weighted Average
Description	Fair Value		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.

The tables below include a roll-forward of the Company's financial instruments for the three and nine month periods ended September 30, 2013 and 2012 (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, 2013



(In thousands)	Beginning Balance as of June 30, 2013			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 September 30, 2013
Assets:
Investments at fair value-
Agency residential mortgage-backed securities	$	27,397		$	(1,844	)	$	—		$	875		$	10,605	$	—		$	—	$	37,033
Private label residential mortgage-backed securities	694,510			7,289			11,187			(5,865		)	106,194		(161,333		)	—		651,982
Private label commercial mortgage-backed securities	23,906			161			647			139			21,760		(13,342		)	—		33,271
Commercial mortgage loans	7,563			31			—			411			6,931		—			—		14,936
Other asset-backed securities	39,840			(658		)	38			60			8,334		(2,359		)	—		45,255
Total investments at fair value	793,216			4,979			11,872			(4,380		)	153,824		(177,034		)	—		782,477
Financial derivatives- assets at fair value-
Credit default swaps on asset-backed securities	21,134			—			(3,113		)	2,995			58		(3,459		)	—		17,615
Total financial derivatives- assets at fair value	21,134			—			(3,113		)	2,995			58		(3,459		)	—		17,615
Total investments and financial derivatives-assets at fair value	$	814,350		$	4,979		$	8,759		$	(1,385	)	$	153,882	$	(180,493	)	$	—	$	800,092
Liabilities:
Financial derivatives- liabilities at fair value-
Credit default swaps on asset-backed securities	$	(541	)	$	—		$	(2	)	$	222		$	—	$	2		$	—	$	(319	)
Total financial derivatives- liabilities at fair value	(541		)	—			(2		)	222			—		2			—		(319		)
Securitized debt:
Securitized debt	(1,168		)	(10		)	—			30			110		—			—		(1,038		)
Total securitized debt	(1,168		)	(10		)	—			30			110		—			—		(1,038		)
Total financial derivatives- liabilities at fair value and securitized debt	$	(1,709	)	$	(10	)	$	(2	)	$	252		$	110	$	2		$	—	$	(1,357	)

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, 2013, as well as Level 3 financial instruments disposed of by the Company during the three month period ended September 30, 2013. For Level 3 financial instruments held by the Company at September 30, 2013, change in net unrealized gain (loss) of $4.3 million, $1.0 million, $2.2 million, and $30.0 thousand, for the three month period ended September 30, 2013 relate to investments, financial derivatives–assets, financial derivatives–liabilities, and securitized debt, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Three Month Period Ended September 30, 2012



(In thousands)	Ending Balance as of June 30, 2012			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 September 30, 2012
Assets:
Investments at fair value-
Agency residential mortgage-backed securities	$	4,667		$	(534	)	$	111	$	(314	)	$	1,057	$	(1,160	)	$	—	$	3,827
Private label residential mortgage-backed securities	385,059			6,182			5,440		24,013			92,412		(55,181		)	—		457,925
Private label commercial mortgage-backed securities	28,405			271			2,905		(293		)	57,195		(39,287		)	—		49,196
Commercial mortgage loans	4,650			21			—		(21		)	—		—			—		4,650
Total investments at fair value	422,781			5,940			8,456		23,385			150,664		(95,628		)	—		515,598
Financial derivatives- assets at fair value-
Credit default swaps on asset-backed securities	38,759			—			3,963		(3,823		)	105		(7,544		)	—		31,460
Total financial derivatives- assets at fair value	38,759			—			3,963		(3,823		)	105		(7,544		)	—		31,460
Total investments and financial derivatives-assets at fair value	$	461,540		$	5,940		$	12,419	$	19,562		$	150,769	$	(103,172	)	$	—	$	547,058
Liabilities:
Securitized debt	$	(1,415	)	$	(15	)	$	—	$	(51	)	$	42	$	—		$	—	$	(1,439	)
Total securitized debt	$	(1,415	)	$	(15	)	$	—	$	(51	)	$	42	$	—		$	—	$	(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 $(51.0) thousand, for the three month period ended September 30, 2012 relate to investments, financial derivatives–assets, and securitized debt, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Nine Month Period Ended September 30, 2013



(In thousands)	Beginning Balance as of December 31, 2012			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 September 30, 2013
Assets:
Investments at fair value-
Agency residential mortgage-backed securities	$	6,644		$	(3,846	)	$	—		$	1,180		$	33,055	$	—		$	—	$	37,033
Private label residential mortgage-backed securities	528,366			20,401			30,977			11,518			363,056		(302,336		)	—		651,982
Private label commercial mortgage-backed securities	19,327			258			(477		)	2,612			58,928		(47,377		)	—		33,271
Commercial mortgage loans	9,546			58			482			497			9,481		(5,128		)	—		14,936
Other asset-backed securities	—			(775		)	569			(866		)	56,435		(10,108		)	—		45,255
Total investments at fair value	563,883			16,096			31,551			14,941			520,955		(364,949		)	—		782,477
Financial derivatives- assets at fair value-
Credit default swaps on asset-backed securities	36,031			—			(404		)	(1,497		)	149		(16,664		)	—		17,615
Total financial derivatives- assets at fair value	36,031			—			(404		)	(1,497		)	149		(16,664		)	—		17,615
Total investments and financial derivatives-assets at fair value	$	599,914		$	16,096		$	31,147		$	13,444		$	521,104	$	(381,613	)	$	—	$	800,092
Liabilities:
Financial derivatives- liabilities at fair value-
Credit default swaps on asset-backed securities	$	(1	)	$	—		$	(59	)	$	(318	)	$	—	$	59		$	—	$	(319	)
Total financial derivatives- liabilities at fair value	(1		)	—			(59		)	(318		)	—		59			—		(319		)
Securitized debt:
Securitized debt	(1,335		)	(31		)	—			36			292		—			—		(1,038		)
Total securitized debt	(1,335		)	(31		)	—			36			292		—			—		(1,038		)
Total financial derivatives- liabilities at fair value and securitized debt	$	(1,336	)	$	(31	)	$	(59	)	$	(282	)	$	292	$	59		$	—	$	(1,357	)

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, 2013, as well as Level 3 financial instruments disposed of by the Company during the nine month period ended September 30, 2013. For Level 3 financial instruments held by the Company at September 30, 2013, change in net unrealized gain (loss) of $19.6 million, $(8.8) million, $(0.3) million, and $36.0 thousand, for the nine month period ended September 30, 2013 relate to investments, financial derivatives–assets, financial derivatives–liabilities, and securitized debt, respectively.

Level 3—Fair Value Measurement Using Significant Unobservable Inputs:

Nine Month Period Ended September 30, 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 September 30, 2012
Assets:
Investments at fair value-
U.S. Treasury and Agency residential mortgage-backed securities	$	5,337	$	(1,177	)	$	111		$	(679	)	$	1,929	$	(1,160	)	$	—	$	3,827
Private label residential mortgage-backed securities	417,533		15,471			12,489			49,149			251,030		(287,747		)	—		457,925
Private label commercial mortgage-backed securities	16,093		527			3,213			990			79,911		(51,538		)	—		49,196
Commercial mortgage loans	4,400		71			—			179			—		—			—		4,650
Total investments at fair value	443,363		14,358			15,813			49,639			332,870		(340,445		)	—		515,598
Financial derivatives- assets at fair value -
Credit default swaps on asset-backed securities	61,498		—			(1,514		)	4,285			330		(33,139		)	—		31,460
Total financial derivatives- assets at fair value	61,498		—			(1,514		)	4,285			330		(33,139		)	—		31,460
Total investments and financial derivatives- assets at fair value	$	504,861	$	14,358		$	14,299		$	53,924		$	333,200	$	(373,584	)	$	—	$	547,058
Liabilities:
Securitized debt	$	—	$	(44	)	$	—		$	(30	)	$	157	$	(1,522	)	$	—	$	(1,439	)
Total securitized debt	$	—	$	(44	)	$	—		$	(30	)	$	157	$	(1,522	)	$	—	$	(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 $(30.0) thousand, for the nine month period ended September 30, 2012 relate to investments, financial derivatives–assets, and securitized debt, respectively.