14. FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company follows FASB ASC Topic 820-10, Fair Value Measurement ("ASC 820-10"), which expands the application of fair value accounting. ASC 820-10 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosure of fair value measurements. ASC 820-10 determines fair value to be the price that would be received for a financial instrument in a current sale, which assumes an orderly transaction between market participants on the measurement date. The financial instruments recorded at fair value on a recurring basis in the Company's consolidated financial statements are derivative instruments, MSRs and loans held for sale. ASC 820-10 specifies a hierarchy of valuation techniques based on the inputs used in measuring fair value. In accordance with ASC 820-10, these inputs are summarized in the three broad levels listed below:

The three levels of inputs that may be used to measure fair value are as follows:

        Level I—Quoted prices in active markets for identical assets or liabilities.

        Level II—Prices are determined using other significant observable inputs. Observable inputs are inputs that other market participants would use in pricing a security. These may include quoted prices for similar securities, interest rates, prepayment speeds, credit risk and others.

        Level III—Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment at the end of the period), unobservable inputs may be used.

GAAP requires disclosure of fair value information about financial instruments, whether or not recognized in the financial statements, for which it is practical to estimate the value. In cases where quoted market prices are not available, fair values are based upon the application of discount rates to estimated future cash flows using market yields, or other valuation methodologies. Any changes to the valuation methodology will be reviewed by the Company's management to ensure the changes are appropriate. The methods used may produce a fair value calculation that is not indicative of net realizable value or reflective of future fair values. Furthermore, while the Company anticipates that the valuation methods are appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may fall within periods of market dislocation, during which price transparency may be reduced.

Financial Instruments reported at fair value

The Company has certain assets and liabilities that are required to be recorded at fair value on a recurring basis in accordance with GAAP. Included in financial instruments reported at fair value in the Company's consolidated financial statements are MSRs, loan commitments, forward sale commitments, loans held for sale and an embedded conversion option related to the Company's 2015 Convertible Notes. The carrying values of cash and cash equivalents, restricted cash, interest receivable and accrued expenses approximate their fair values due to their short-term nature.

The following table summarizes the levels in the fair value hierarchy into which the Company's financial instruments were categorized as of December 31, 2013 and 2012 ($ in thousands):

	Fair Value as of December 31, 2013

	Level I		Level II		Level III			Total
Loans held for sale	$	—	$	89,233	$	—		$	89,233
Mortgage servicing rights	$	—	$	—		59,640		$	59,640
Derivative assets:
Loan commitments	$	—	$	—	$	1,886		$	1,886
Forward sale commitments	$	—	$	—	$	272		$	272
Right to acquire MSRs	$	—	$	—	$	1,717		$	1,717
Derivative liabilities:
Forward sale commitments	$	—	$	—	$	(500	)	$	(500	)

	Fair Value as of December 31, 2012

	Level I		Level II		Level III			Total
Embedded conversion option	$	—	$	—	$	(1,825)	(1)	$	(1,825	)

(1): On June 26, 2013, the Company obtained stockholder approval to issue shares in excess of 20% of total shares outstanding. This permitted the Company to issue, at its option, 100% common stock to settle any conversions of the 2015 Convertible Notes. As a result, the embedded conversion option was no longer separately valued and accounted for as a derivative liability. As of June 26, 2013, the conversion option's cumulative value of $86 thousand was reclassified to additional paid in capital and will no longer be marked-to-market through earnings. See Note 6 for information on the derivative liability reclassification.

There were no transfers between the levels as of December 31, 2013 and 2012. Transfers between levels are recognized based on the fair value of the financial instrument at the beginning of the period.

Loan commitments and forward sale commitments are valued based on a discounted cash flow model that incorporates changes in interest rates during the period. The MSRs and right to acquire MSRs are valued based on discounted cash flow models that calculate the present value of estimated future net servicing income. The model considers contractually specified servicing fees, prepayment assumptions, delinquency rates, late charges, other ancillary revenue, costs to service and other economic factors. The loans held for sale are valued based on discounted cash flow models that incorporate quoted observable prices from market participants. The embedded conversion option fair value analysis as of December 31, 2012 reflected the contractual terms of the derivative, including the period to maturity, and used observable market-based inputs to the extent available, including interest rate curves, spot and market forward points. The valuation of derivative instruments are determined using widely accepted valuation techniques, including market yield analyses and discounted cash flow analysis on the expected cash flows of each derivative.

The following table summarizes the significant unobservable inputs the Company used to value financial instruments categorized within Level III as of December 31, 2013 ($ in thousands):

					Unobservable Input

Asset Category	Fair Value			Primary Valuation Technique	Input	Range	Weighted Average
Mortgage servicing rights	$	59,640		Discounted cash flow	Discount rate	8 – 14%		12	%
Loan commitments	$	1,886		Discounted cash flow	Discount rate	8%		8	%
Right to acquire MSRs	$	1,717		Discounted cash flow	Discount rate	8%		8	%
Forward sale commitments	$	(228	)	Discounted cash flow	Discount rate	8 – 12%		8	%

The following table summarizes the significant unobservable inputs the Company used to value financial instruments categorized within Level III as of December 31, 2012 ($ in thousands):

					Unobservable Input

Asset Category	Fair Value			Primary Valuation Technique	Input	Range	Weighted Average
Embedded conversion option	$	(1,825	)	Option Pricing Model	Volatility	16.4% – 17.4%		16.4	%

The table above is not intended to be all-inclusive, but instead is intended to capture the significant unobservable inputs relevant to the Company's determination of fair values.

Changes in market yields, discount rates or EBITDA multiples, each in isolation, may have changed the fair value of the financial instruments. Generally, an increase in market yields or discount rates or decrease in EBITDA multiples may have resulted in a decrease in the fair value of the financial instruments.

The Company's management is responsible for the Company's fair value valuation policies, processes and procedures related to Level III financial instruments. The management reports to the CFO, who has final authority over the valuation of the Company's Level III financial instruments.

The following table summarizes the change in derivative assets and liabilities classified as Level III related to mortgage banking activities for the year ended December 31, 2013 ($ in thousands):

	As of and for the year ended December 31, 2013

Derivative assets and liabilities acquired in the ACRE Capital acquisition, net (See Note 18)	$	182
Settlements		(2,098	)
Realized gains (losses) recorded in net income(1)		1,916
Unrealized gains (losses) recorded in net income(1)		3,375


Ending balance, as of December 31, 2013	$	3,375

(1): Realized and unrealized gains (losses) from derivatives are included within gains from mortgage banking activities in the consolidated statements of operations.

The change in the embedded conversion option classified as Level III is as follows for the year ended December 31, 2013 and 2012 ($ in thousands):

	As of and for the year ended December 31,

	2013			2012
Beginning balance, as of December 31, 2012	$	(1,825	)	$	—
Written option sold specific to the convertible debt offering		—			(1,728	)
Unrealized gain (loss) on the embedded conversion option		1,739	(1)		(97	)
Reclassification to additional paid in capital		86			—


Ending balance, as of December 31, 2013	$	—		$	(1,825	)

(1): The unrealized gain on the embedded conversion option is included within changes in fair value of derivatives in the consolidated statements of operations for the year ended December 31, 2013. The Company reclassified certain prior quarter and prior year amounts included within other interest expense related to the fair value of the derivative to conform to the Company's presentation for the year ended December 31, 2013. Due to the inherent uncertainty of determining the fair value of derivative liabilities that do not have a readily available market value, the fair value of the Company's embedded conversion option fluctuated from March 31, 2013 to June 26, 2013. Additionally, the fair value of the Company's embedded conversion option may have differed significantly from the values that would have been used had a ready market existed for such derivative liability.

See Note 4 for the changes in MSRs that are classified as Level III.

The following table presents the carrying values and fair values of the Company's financial assets and liabilities recorded at cost as of December 31, 2013 and 2012. Changes in market yields, credit quality and other variables may change the fair value of the Company's assets and liabilities. As of December 31, 2013 and 2012, the fair value of the Company's financial instruments recorded at cost is as follows ($ in thousands).

	As of December 31,

	2013				2012
	Carrying Value		Fair Value		Carrying Value		Fair Value
Financial instruments not recorded at fair value:
Loans held for investment	$	958,495	$	958,495	$	353,500	$	353,500
Financial liabilities:
Secured funding agreements	$	264,419	$	264,419	$	144,256	$	144,256
Convertible notes		67,815		67,815		67,289		67,289
Commercial mortgage-backed securitization debt (consolidated VIE)		395,027		395,027		—		—