FAIR VALUE OF FINANCIAL INSTRUMENTS

ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and also requires an entity to consider all aspects of nonperformance risk, including the entity's own credit standing, when measuring fair value of a liability. ASC Topic 820 established a valuation hierarchy of three levels as follows:


•	Level 1 – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities as of the measurement date. The fair value measurement of the Company's Eurodollar futures contracts are included in this category.

•

Level 2 – Inputs include quoted prices in active markets for similar assets or liabilities; quoted prices in inactive markets for identical or similar assets or liabilities; or inputs either directly observable or indirectly observable through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life. The Company’s assets and liabilities measured at fair value that are generally included in this category are Agency MBS, certain non-Agency MBS, and interest rate swaps.

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Level 3 – Unobservable inputs are supported by little or no market activity. The unobservable inputs represent management’s best estimate of how market participants would price the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. The Company’s assets and liabilities measured at fair value that are generally included in this category are certain non-Agency MBS.

The following table presents the fair value of the Company’s assets and liabilities, segregated by the hierarchy level of the fair value estimate, that are measured at fair value on a recurring basis as of the dates indicated:



	December 31, 2013
	Fair Value		Level 1 - Unadjusted Quoted Prices in Active Markets		Level 2 - Observable Inputs		Level 3 - Unobservable Inputs
Assets:
Mortgage-backed securities	$	4,018,161	$	—	$	3,944,681	$	73,480
Derivative assets	18,488		—		18,488		—
Total assets carried at fair value	$	4,036,649	$	—	$	3,963,169	$	73,480
Liabilities:
Derivative liabilities	$	6,681	$	5,345	$	1,336	$	—
Total liabilities carried at fair value	$	6,681	$	5,345	$	1,336	$	—



	December 31, 2012
	Fair Value		Level 1 - Unadjusted Quoted Prices in Active Markets		Level 2 - Observable Inputs		Level 3 - Unobservable Inputs
Assets:
Mortgage-backed securities	$	4,103,981	$	—	$	3,998,761	$	105,220
Other investments	25		—		—		25
Total assets carried at fair value	$	4,104,006	$	—	$	3,998,761	$	105,245
Liabilities:
Derivative liabilities	$	42,537	$	—	$	42,537	$	—
Total liabilities carried at fair value	$	42,537	$	—	$	42,537	$	—

The Company did not have assets or liabilities measured at fair value on a non-recurring basis as of December 31, 2013 or December 31, 2012.

The Company’s valuation of its interest rate swaps is determined using the income approach. Derivative assets and liabilities include interest rate swaps and Eurodollar futures. The primary input into the valuation of interest rate swaps is the forward interest rate swap curve, which is considered an observable input and thus their fair values are considered Level 2 measurements. The Company's valuation of its Eurodollar futures is based on the closing exchange prices. Accordingly, these financial futures are classified as Level 1.

The Company’s Agency MBS, as well a majority of its non-Agency MBS, are substantially similar to securities that either are currently actively traded or have been recently traded in their respective market. Their fair values are derived from an average of multiple dealer quotes and thus are considered Level 2 fair value measurements. The Company’s remaining non-Agency MBS are comprised of securities for which there are not substantially similar securities that trade frequently, and their fair values are therefore considered Level 3 measurements. The Company determines the fair value of its Level 3 securities by discounting the estimated future cash flows derived from cash flow models using assumptions that are confirmed to the extent possible by third party dealers or other pricing indicators. Significant inputs into those pricing models are Level 3 in nature due to the lack of readily available market quotes. Information utilized in those pricing models include the security’s credit rating, coupon rate, estimated prepayment speeds, expected weighted average life, collateral composition, estimated future interest rates, expected credit losses, and credit enhancement as well as certain other relevant information. Significant changes in any of these inputs in isolation would result in a significantly different fair value measurement. Generally Level 3 assets are most sensitive to the default rate and severity assumptions.

The table below presents information about the significant unobservable inputs used in the fair value measurement for the Company's Level 3 non-Agency CMBS and RMBS as of December 31, 2013:



	Quantitative Information about Level 3 Fair Value Measurements ⁽¹⁾
	Prepayment Speed	Default Rate		Severity		Discount Rate
Non-Agency CMBS	20 CPY	2.5	%	35.0	%	8.7	%
Non-Agency RMBS	10 CPR	1.0	%	19.2	%	8.1	%


(1)	Data presented are weighted averages.

The following table presents the activity of the instruments fair valued at Level 3 during the year ended December 31, 2013:



	Year Ended
	December 31, 2013
	Level 3 Fair Values
	Non-Agency CMBS			Non-Agency RMBS			Other			Total assets
Balance as of January 1, 2011	$	123,703		$	10,296		$	25		$	134,024
Purchases	—			7,500			—			7,500
Transfers out to Level 2	(4,670		)	—			—			(4,670		)
Change in fair value included in OCI	(59		)	86			—			27
Principal payments	(18,437		)	(12,804		)	—			(31,241		)
(Amortization) accretion	(435		)	40			—			(395		)
Balance as of December 31, 2012	$	100,102		$	5,118		$	25		$	105,245
Purchases	26,021			—			—			26,021
Sales/write-offs to net income	—			—			(25		)	(25		)
Change in fair value included in OCI	(6,026		)	5			—			(6,021		)
Principal payments	(49,167		)	(2,421		)	—			(51,588		)
(Amortization) accretion	(197		)	45			—			(152		)
Balance as of December 31, 2013	$	70,733		$	2,747		$	—		$	73,480

The following table presents a summary of the recorded basis and estimated fair values of the Company’s financial instruments as of the dates indicated:



	December 31, 2013				December 31, 2012
	Recorded Basis		Fair Value		Recorded Basis		Fair Value
Assets:
Mortgage-backed securities	$	4,018,161	$	4,018,161	$	4,103,981	$	4,103,981
Securitized mortgage loans, net ⁽¹⁾	54,748		45,750		70,823		61,916
Other investments ⁽¹⁾	675		633		858		810
Derivative assets	18,488		18,488		—		—
Liabilities:
Repurchase agreements ⁽²⁾	$	3,580,754	$	3,580,997	$	3,564,128	$	3,564,787
Non-recourse collateralized financing ⁽¹⁾	12,914		12,414		30,504		30,756
Derivative liabilities	6,681		6,681		42,537		42,537

(1) The Company determines the fair value of its securitized mortgage loans and other investments and its non-recourse collateralized financing using internally developed cash flow models with inputs similar to those used to estimate fair value of the Company's Level 3 non-Agency MBS.

(2) The difference between the recorded basis of repurchase agreements and their fair value is the deferred cost of the 2-year repurchase facility.