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, pricing services and 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 of its 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 December 31, 2013:



(In thousands)
Description	Level 1			Level 2			Level 3			Total
Assets:
Cash and cash equivalents	$	183,489		$	—		$	—		$	183,489
Investments, at fair value-
Agency residential mortgage-backed securities	$	—		$	989,842		$	40,504		$	1,030,346
Private label residential mortgage-backed securities	—			—			580,772			580,772
Private label commercial mortgage-backed securities	—			—			32,994			32,994
Commercial mortgage loans	—			—			23,887			23,887
Residential mortgage loans	—			—			24,062			24,062
Other asset-backed securities	—			—			38,069			38,069
Total investments, at fair value	—			989,842			740,288			1,730,130
Financial derivatives–assets, at fair value-
Credit default swaps on asset-backed securities	—			—			16,646			16,646
Credit default swaps on corporate bond indices	—			14,273			—			14,273
Credit default swaps on asset-backed indices	—			4,937			—			4,937
Interest rate swaps	—			23,553			—			23,553
Total return swaps	—			4			—			4
Options	—			251			—			251
Total financial derivatives–assets, at fair value	—			43,018			16,646			59,664
Repurchase agreements	—			27,962			—			27,962
Total investments and financial derivatives–assets, at fair value and repurchase agreements	$	—		$	1,060,822		$	756,934		$	1,817,756
Liabilities:
Investments sold short, at fair value-
Agency residential mortgage-backed securities	$	—		$	(811,957	)	$	—		$	(811,957	)
Government debt	—			(27,288		)	—			(27,288		)
Common stock	(6,369		)	—			—			(6,369		)
Total investments sold short, at fair value	(6,369		)	(839,245		)	—			(845,614		)
Financial derivatives–liabilities, at fair value-
Credit default swaps on corporate bond indices	—			(24,949		)	—			(24,949		)
Credit default swaps on asset-backed indices	—			(11,866		)	—			(11,866		)
Credit default swaps on asset-backed securities	—			—			(350		)	(350		)
Interest rate swaps	—			(5,064		)	—			(5,064		)
Total return swaps	—			(67		)	—			(67		)
Options	—			(84		)	—			(84		)
Futures	(2,373		)	—			—			(2,373		)
Forwards	—			(38		)	—			(38		)
Total financial derivatives–liabilities, at fair value	(2,373		)	(42,068		)	(350		)	(44,791		)
Securitized debt	—			—			(983		)	(983		)
Total investments sold short, financial derivatives–liabilities, and securitized debt, at fair value	$	(8,742	)	$	(881,313	)	$	(1,333	)	$	(891,388	)

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, 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 December 31, 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⁾	$	550,701	Market Quotes	Non Binding Indicative Price	$	1.80		$	110.35		$	78.09
Private label residential mortgage-backed securities	67,158		Discounted Cash Flows	Yield	3.8		%	20.5		%	8.0		%
				Projected Collateral Prepayments	6.9		%	64.5		%	29.7		%
				Projected Collateral Losses	4.3		%	35.2		%	17.4		%
				Projected Collateral Recoveries	0.3		%	17.1		%	9.1		%
				Projected Collateral Scheduled Amortization	14.1		%	87.3		%	43.8		%
											100.0		%
Private label commercial mortgage-backed securities	3,480		Discounted Cash Flows	Yield	9.2		%	18.2		%	13.5		%
				Projected Collateral Losses	0.2		%	0.2		%	0.2		%
				Projected Collateral Recoveries	15.4		%	15.4		%	15.4		%
				Projected Collateral Scheduled Amortization	84.4		%	84.4		%	84.4		%
											100.0		%
Private label commercial mortgage-backed securities and commercial mortgage loans	34,489		Market Quotes	Non Binding Indicative Price	$	14.25		$	102.89		$	74.24
Performing commercial mortgage loans	8,788		Discounted Cash Flows	Yield	12.7		%	12.8		%	12.7		%
Non-performing commercial mortgage loans	10,123		Discounted Cash Flows	Yield	15.0		%	15.0		%	15.0		%
				Months to Resolution	5			7			6
Non-performing residential mortgage loan pools	24,062		Discounted Cash Flows	Yield	7.4		%	7.4		%	7.4		%
				Months to Resolution	16.3			16.3			16.3
Agency interest only residential mortgage-backed securities	38,783		Market Quotes	Non Binding Indicative Price	$	6.26		$	33.77		$	14.53
Agency interest only residential mortgage-backed securities	1,721		Option Adjusted Spread ("OAS")	LIBOR OAS⁽²⁾	349			645			422
				Projected Collateral Prepayments	49.0		%	58.1		%	51.2		%
				Projected Collateral Scheduled Amortization	41.9		%	51.0		%	48.8		%
											100.0		%
Credit default swaps on asset-backed securities	16,296		Net Discounted Cash Flows	Projected Collateral Prepayments	19.3		%	59.0		%	29.9		%
				Projected Collateral Losses	15.5		%	47.8		%	34.8		%
				Projected Collateral Recoveries	8.2		%	15.2		%	13.1		%
				Projected Collateral Scheduled Amortization	15.7		%	41.2		%	22.2		%
											100.0		%


(1)	Includes securitized debt with a fair value of $1.0 million as of December 31, 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 and residential 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 and 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 bond 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, financial derivatives–liabilities, and securitized debt, 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 years ended December 31, 2013, 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:

Year Ended December 31, 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 December 31, 2013
Assets:
Investments, at fair value-
Agency residential mortgage-backed securities	$	6,644		$	(5,929	)	$	833		$	3,323		$	42,051	$	(6,418	)	$	—	$	40,504
Private label residential mortgage-backed securities	528,366			26,119			43,823			12,643			425,864		(456,043		)	—		580,772
Private label commercial mortgage-backed securities	19,327			402			1,030			3,069			92,929		(83,763		)	—		32,994
Commercial mortgage loans	9,546			171			844			652			19,587		(6,913		)	—		23,887
Residential mortgage loans	—			—			—			—			24,062		—			—		24,062
Other asset-backed securities	—			(641		)	647			(690		)	56,436		(17,683		)	—		38,069
Total investments, at fair value	563,883			20,122			47,177			18,997			660,929		(570,820		)	—		740,288
Financial derivatives–assets, at fair value-
Credit default swaps on asset-backed securities	36,031			—			(2,826		)	1,070			204		(17,833		)	—		16,646
Total financial derivatives– assets, at fair value	36,031			—			(2,826		)	1,070			204		(17,833		)	—		16,646
Total investments and financial derivatives–assets, at fair value	$	599,914		$	20,122		$	44,351		$	20,067		$	661,133	$	(588,653	)	$	—	$	756,934
Liabilities:
Financial derivatives–liabilities, at fair value-
Credit default swaps on asset-backed securities	$	(1	)	$	—		$	(78	)	$	(349	)	$	—	$	78		$	—	$	(350	)
Total financial derivatives– liabilities, at fair value	(1		)	—			(78		)	(349		)	—		78			—		(350		)
Securitized debt:
Securitized debt	(1,335		)	(38		)	—			20			370		—			—		(983		)
Total securitized debt	(1,335		)	(38		)	—			20			370		—			—		(983		)
Total financial derivatives– liabilities and securitized debt, at fair value	$	(1,336	)	$	(38	)	$	(78	)	$	(329	)	$	370	$	78		$	—	$	(1,333	)

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, 2013, as well as Level 3 financial instruments disposed of by the Company during the year ended December 31, 2013. For Level 3 financial instruments held by the Company at December 31, 2013, change in net unrealized gain (loss) of $27.0 million, $(8.4) million, $(0.3) million, and $20.0 thousand, for the year ended December 31, 2013 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 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-
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 and securitized debt, at fair value	$	—	$	(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 $(23.0) thousand 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 31, 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/ Payments		Sales/ Issuances			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.