Fair Value of Financial Instruments

A three-level valuation hierarchy exists for disclosure of fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels are defined as follows:


•	Level 1 Inputs – Quoted prices for identical instruments in active markets.


•	Level 2 Inputs – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.


•	Level 3 Inputs – Instruments with primarily unobservable value drivers.

The following tables present the Company's assets and liabilities measured at fair value on a recurring basis.



	June 30, 2016
	Fair Value Measurements Using:
					Total at
$ in thousands	Level 1	Level 2	Level 3		Fair Value
Assets:
Mortgage-backed and credit risk transfer securities^{(1) (2)}	—	15,631,520	(6,493	)	15,625,027
U.S. Treasury securities ⁽³⁾	—	152,701	—		152,701
Derivative assets	—	5,502	—		5,502
Total assets	—	15,789,723	(6,493	)	15,783,230
Liabilities:
Derivative liabilities	—	447,738	—		447,738
Total liabilities	—	447,738	—		447,738



	December 31, 2015
	Fair Value Measurements Using:
					Total at
$ in thousands	Level 1	Level 2	Level 3		Fair Value
Assets:
Mortgage-backed and credit risk transfer securities^{(1) (2)}	—	16,091,657	(25,722	)	16,065,935
Derivative assets	—	8,659	—		8,659
Total assets	—	16,100,316	(25,722	)	16,074,594
Liabilities:
Derivative liabilities	—	238,148	—		238,148
Total liabilities	—	238,148	—		238,148


(1)	For more detail about the fair value of the Company's MBS and GSE CRTs, refer to Note 4 - "Mortgage-Backed and Credit Risk Transfer Securities."

(2)

The Company's GSE CRTs purchased prior to August 24, 2015 are accounted for as hybrid financial instruments with an embedded derivative. The hybrid instruments consist of debt host contracts classified as Level 2 and embedded derivatives classified as Level 3. As of June 30, 2016, the net embedded derivative liability position of $6.5 million includes $5.8 million of embedded derivatives in an asset position and $12.3 million of embedded derivatives in a liability position. As of December 31, 2015, the net embedded derivative liability position of $25.7 million includes $1.0 million of embedded derivatives in an asset position and $26.7 million of embedded derivatives in a liability position.


(3)	Similar to the Company's MBS and GSE CRTs, the fair value of the Company's U.S. Treasury securities are based upon prices obtained from third-party pricing vendors.

The following table shows a reconciliation of the beginning and ending fair value measurements of the Company's GSE CRT embedded derivatives, which the Company has valued utilizing Level 3 inputs:



	Three Months Ended June 30,				Six Months Ended June 30,
$ in thousands	2016		2015		2016		2015
Beginning balance	(22,706	)	(5,457	)	(25,722	)	(21,495	)
Sales and settlements	5,097		1,676		6,017		2,468
Total net gains / (losses) included in net income:	—		—		—
Realized gains/(losses), net	(5,097	)	(1,676	)	(6,017	)	(2,468	)
Unrealized gains/(losses), net	16,213		(4,915	)	19,229		11,123
Ending balance	(6,493	)	(10,372	)	(6,493	)	(10,372	)

The following table summarizes significant unobservable inputs used in the fair value measurement of the Company's GSE CRT embedded derivatives:



	Fair Value at		Valuation	Unobservable		Weighted
$ in thousands	June 30, 2016		Technique	Input	Range	Average
GSE CRT Embedded Derivatives	(6,493	)	Market Comparables	Prepayment Rate	6.84% - 23.41%	11.55	%
			Vendor Pricing	Default Rate	0.10% - 0.43%	0.16	%



	Fair Value at		Valuation	Unobservable		Weighted
$ in thousands	December 31, 2015		Technique	Input	Range	Average
GSE CRT Embedded Derivatives	(25,722	)	Market Comparables	Prepayment Rate	5.72% - 14.37%	7.83	%
			Vendor Pricing	Default Rate	0.10% - 0.35%	0.16	%

These significant unobservable inputs change according to market conditions and security performance. Prepayment rate and default rate are used to estimate the weighted-average life of GSE CRTs in order to identify GSE corporate debt with a similar maturity. Therefore, changes in prepayment rate and default rate do not have an explicit directional impact on the fair value measurement.

The following table presents the carrying value and estimated fair value of the Company's financial instruments that are not carried at fair value on the condensed consolidated balance sheets at June 30, 2016 and December 31, 2015:



	June 30, 2016		December 31, 2015
$ in thousands	Carrying Value	Estimated Fair Value	Carrying Value	Estimated Fair Value
Financial Assets
Commercial loans, held-for-investment	272,502	273,156	209,062	209,790
Other assets	108,283	108,283	115,072	115,072
Total	380,785	381,439	324,134	324,862
Financial Liabilities
Repurchase agreements	11,768,647	11,768,485	12,126,048	12,133,252
Secured loans	1,650,000	1,650,000	1,650,000	1,650,000
Exchangeable senior notes	395,800	390,000	394,573	376,500
Total	13,814,447	13,808,485	14,170,621	14,159,752

The following describes the Company’s methods for estimating the fair value for financial instruments.

•

The estimated fair value of commercial loans held-for-investment is a Level 3 fair value measurement. New commercial loans are carried at their unpaid principal balance until the end of the calendar year in which they were originated or purchased unless market factors indicate cost may not be a reliable indicator of fair value. Subsequent to the year of origination or purchase, commercial loan investments are valued on at least an annual basis by an independent third party valuation agent using a discounted cash flow technique.


•	The estimated fair value of FHLBI stock, included in "Other assets," is a Level 3 fair value measurement. FHLBI stock may only be sold back to the FHLBI at its discretion at cost. As a result, the cost of the FHLBI stock approximates its fair value. At June 30, 2016 and December 31, 2015, the fair value of FHLBI stock is $74.3 million and $75.4 million, respectively.


•	The estimated fair value of investments in unconsolidated ventures, included in "Other assets," is a Level 3 fair value measurement. The fair value measurement is based on the net asset value per share of the Company's investments. At June 30, 2016 and December 31, 2015, the fair value of investments in unconsolidated ventures is $33.0 million and $38.4 million, respectively.


•	The estimated fair value of repurchase agreements is a Level 3 fair value measurement based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best reflect current market interest rates that would be offered for repurchase agreements with similar characteristics and credit quality.


•	The estimated fair value of secured loans is a Level 3 fair value measurement. The secured loans have floating rates based on an index plus a spread and the spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these secured loans are at market, and thus the carrying amount approximates fair value.


•	The estimated fair value of the exchangeable senior notes issued is a Level 2 fair value measurement based on valuation obtained from a third-party pricing service.