Fair Value of Financial Instruments

For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to determine the fair value of financial instruments. This hierarchy prioritizes relevant market inputs in order to determine an “exit price” at the measurement date, or the price at which an asset could be sold or a liability could be transferred in an orderly process that is not a forced liquidation or distressed sale. Level 1 inputs are observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 inputs are observable inputs other than quoted prices for an asset or liability that are obtained through corroboration with observable market data. Level 3 inputs are unobservable inputs (e.g., our own data or assumptions) that are used when there is little, if any, relevant market activity for the asset or liability required to be measured at fair value.

In certain cases, inputs used to measure fair value fall into different levels of the fair value hierarchy. In such cases, the level at which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input requires judgment and considers factors specific to the asset or liability being measured.

The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value at September 30, 2017 and December 31, 2016.

Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities



	September 30, 2017				December 31, 2016
	Carrying Value		Fair Value		Carrying Value		Fair Value
(In Thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Residential loans, held-for-sale
At fair value	$	924,594	$	924,594	$	834,193	$	834,193
At lower of cost or fair value	1,087		1,227		1,206		1,365
Residential loans, held-for-investment
At fair value	3,259,239		3,259,239		3,052,652		3,052,652
Trading securities	820,134		820,134		445,687		445,687
Available-for-sale securities	536,138		536,138		572,752		572,752
MSRs	62,928		62,928		118,526		118,526
Cash and cash equivalents	257,611		257,611		212,844		212,844
Restricted cash	26,258		26,258		8,623		8,623
Accrued interest receivable	21,256		21,256		18,454		18,454
Derivative assets	11,948		11,948		36,595		36,595
REO ⁽¹⁾	3,020		3,441		5,533		5,560
Margin receivable⁽¹⁾	93,679		93,679		68,038		68,038
FHLBC stock ⁽¹⁾	43,393		43,393		43,393		43,393
Guarantee asset⁽¹⁾	3,049		3,049		4,092		4,092
Commercial loans ⁽¹⁾	—		—		2,700		2,700
Pledged collateral⁽¹⁾	42,933		42,933		42,875		42,875
Liabilities
Short-term debt facilities	$	988,054	$	988,054	$	791,539	$	791,539
Accrued interest payable	18,836		18,836		9,608		9,608
Margin payable	841		841		12,783		12,783
Guarantee obligation	20,101		19,682		21,668		22,181
Derivative liabilities	65,238		65,238		66,329		66,329
ABS issued at fair value, net	944,288		944,288		773,462		773,462
FHLBC long-term borrowings	1,999,999		1,999,999		1,999,999		1,999,999
Convertible notes, net	686,058		705,703		482,195		493,365
Trust preferred securities and subordinated notes, net	138,524		101,138		138,489		96,255


(1)	These assets are included in Other assets on our consolidated balance sheets.

During the three and nine months ended September 30, 2017, we elected the fair value option for $16 million and $32 million of residential senior securities, $167 million and $412 million of subordinate securities, $1.43 billion and $3.72 billion of residential loans (principal balance), and $0.3 million and $8 million of MSRs, respectively. We anticipate electing the fair value option for all future purchases of residential loans that we may sell to third parties or transfer to securitizations, for MSRs purchased or retained from sales of residential loans, and for certain securities we purchase, including IO securities and fixed-rate securities rated investment grade or higher.

The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis at September 30, 2017 and December 31, 2016, as well as the fair value hierarchy of the valuation inputs used to measure fair value.

Table 5.2 – Assets and Liabilities Measured at Fair Value on a Recurring Basis



September 30, 2017	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	4,183,833	$	—	$	—	$	4,183,833
Trading securities	820,134		—		—		820,134
Available-for-sale securities	536,138		—		—		536,138
Derivative assets	11,948		3,010		3,942		4,996
MSRs	62,928		—		—		62,928
Pledged collateral	42,933		42,933		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	3,049		—		—		3,049

Liabilities
Derivative liabilities	$	65,238	$	4,369	$	57,994	$	2,875
ABS issued	944,288		—		—		944,288



December 31, 2016	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	3,886,845	$	—	$	—	$	3,886,845
Trading securities	445,687		—		—		445,687
Available-for-sale securities	572,752		—		—		572,752
Derivative assets	36,595		8,300		24,980		3,315
MSRs	118,526		—		—		118,526
Pledged collateral	42,875		42,875		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	4,092		—		—		4,092

Liabilities
Derivative liabilities	$	66,329	$	5,609	$	56,919	$	3,801
ABS issued	773,462		—		—		773,462

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2017.

Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis



	Assets																		Liabilities
	Residential Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives⁽¹⁾			ABS Issued
(In Thousands)	Residential Loans			Trading Securities			AFS Securities			MSRs			Guarantee Asset			Derivatives⁽¹⁾			ABS Issued
Beginning balance - December 31, 2016	$	3,886,845		$	445,687		$	572,752		$	118,526		$	4,092		$	(486	)	$	773,462
Acquisitions	3,791,471			444,073			31,654			7,957			—			—			286,898
Sales	(3,147,707		)	(87,092		)	(60,801		)	(52,966		)	—			—			—
Principal paydowns	(405,888		)	(13,219		)	(42,325		)	—			—			—			(146,358		)
Gains (losses) in net income, net	62,290			30,685			24,011			(10,589		)	(1,043		)	33,686			30,286
Unrealized losses in OCI, net	—			—			10,847			—			—			—			—
Other settlements, net ⁽²⁾	(3,178		)	—			—			—			—			(31,079		)	—
Ending Balance - September 30, 2017	$	4,183,833		$	820,134		$	536,138		$	62,928		$	3,049		$	2,121		$	944,288


(1)	For the purpose of this presentation, derivative assets and liabilities, which consist of loan purchase commitments, are presented on a net basis.


(2)	Other settlements, net for derivatives represents the transfer of the fair value of loan purchase commitments at the time loans are acquired to the basis of residential loans.

The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and held at September 30, 2017 and 2016. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and nine months ended September 30, 2017 and 2016 are not included in this presentation.

Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at September 30, 2017 and 2016 Included in Net Income



	Included in Net Income
	Three Months Ended September 30,					Nine Months Ended September 30,
(In Thousands)	2017			2016		2017			2016
Assets
Residential loans at Redwood	$	14,359		$	3,818	$	24,227		$	32,202
Residential loans at consolidated Sequoia entities	3,497			9,200		22,949			(18,864		)
Trading securities	(36		)	8,646		24,452			978
Available-for-sale securities	(3		)	—		(248		)	(305		)
MSRs	317			6,549		(1,005		)	(36,738		)
Loan purchase commitments	2,117			5,381		2,121			5,896
Other assets - Guarantee asset	(239		)	307		(1,043		)	(2,070		)

Liabilities
ABS issued	$	(7,771	)	$	10,522	$	(30,286	)	$	(14,419	)

The following table presents information on assets recorded at fair value on a non-recurring basis at September 30, 2017. This table does not include the carrying value and gains or losses associated with the asset types below that were not recorded at fair value on our consolidated balance sheet at September 30, 2017.

Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at September 30, 2017



									Gain (Loss) for
September 30, 2017	Carrying Value		Fair Value Measurements Using						Three Months Ended		Nine Months Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		September 30, 2017		September 30, 2017
Assets
Residential loans, at lower of cost or fair value	$	866	$	—	$	—	$	866	$	18	$	21
REO	1,725		—		—		1,725		—		(81		)

The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the three and nine months ended September 30, 2017 and 2016.

Table 5.6 – Market Valuation Gains and Losses, Net



	Three Months Ended September 30,						Nine Months Ended September 30,
(In Thousands)	2017			2016			2017			2016
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value	$	14,859		$	650		$	29,175		$	11,948
Residential loan purchase commitments	13,276			12,021			33,947			35,508
Commercial loans, at fair value	—			—			—			433
Sequoia securities	—			—			—			1,455
Risk management derivatives, net	(7,077		)	(3,287		)	(13,787		)	(25,281		)
Total mortgage banking activities, net ⁽¹⁾	$	21,058		$	9,384		$	49,335		$	24,063
Investment Fair Value Changes, Net
Residential loans held-for-investment, at Redwood	$	2,881		$	(655	)	$	8,902		$	22,161
Trading securities	607			8,898			30,676			3,728
Valuation adjustments on commercial loans held-for-sale	—			(307		)	300			(307		)
Net investments in Legacy Sequoia entities ⁽²⁾	(1,045		)	(255		)	(3,842		)	(2,086		)
Net investment in Sequoia Choice entity ⁽²⁾	(256		)	—			(256		)	—
Risk sharing investments	(267		)	15			(985		)	(689		)
Risk management derivatives, net	(1,592		)	4,222			(24,557		)	(41,188		)
Impairments on AFS securities	(4		)	—			(248		)	(305		)
Total investment fair value changes, net	$	324		$	11,918		$	9,990		$	(18,686	)
MSR Income (Loss), Net
MSRs	$	(1,351	)	$	1,380		$	(10,842	)	$	(70,489	)
Risk management derivatives, net	(422		)	(6,336		)	1,869			55,874
Total MSR loss, net ⁽³⁾	$	(1,773	)	$	(4,956	)	$	(8,973	)	$	(14,615	)
Total Market Valuation Gains (Losses), Net	$	19,609		$	16,346		$	50,352		$	(9,238	)


(1)	Mortgage banking activities, net presented above does not include fee income or provisions for repurchases that are components of Mortgage banking activities, net presented on our consolidated statements of income, as these amounts do not represent market valuation changes.


(2)	Includes changes in fair value of the residential loans held-for-sale, REO and the ABS issued at the entities, which netted together represent the change in value of our retained investments at the consolidated VIEs.


(3)	MSR income (loss), net presented above does not include net fee income or provisions for repurchases that are components of MSR income, net on our consolidated statements of income, as these amounts do not represent market valuation adjustments.

At September 30, 2017, our valuation policy and processes had not changed from those described in our Annual Report on Form 10-K for the year ended December 31, 2016. The following table provides quantitative information about the significant unobservable inputs used in the valuation of our Level 3 assets and liabilities measured at fair value.

Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments



September 30, 2017	Fair Value			Input Values
(Dollars in Thousands, except Input Values)	Fair Value		Unobservable Input	Range						Weighted Average
Assets
Residential loans, at fair value:
Jumbo fixed-rate loans	$	2,450,845	Whole loan spread to TBA price	$	2.13	-	$	3.15		$	3.13
			Whole loan spread to swap rate	180		-	270		bps	265		bps

Jumbo hybrid loans	168,138		Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate	100		-	190		bps	163		bps

Jumbo loans committed to sell	574,413		Whole loan committed sales price	$	102.42	-	$	103.08		$	102.89

Loans held by Legacy Sequoia ⁽¹⁾	673,134		Liability price				N/A			N/A

Loans held by Sequoia Choice ⁽¹⁾	317,303		Liability price				N/A			N/A

Residential loans, at lower of cost or fair value	866		Loss severity	13		-	30		%	18		%

Trading and AFS securities	1,356,272		Discount rate	2		-	25		%	5		%
			Prepayment rate (annual CPR)	—		-	50		%	10		%
			Default rate	—		-	32		%	3		%
			Loss severity	—		-	40		%	22		%

MSRs	62,928		Discount rate	10		-	35		%	11		%
			Prepayment rate (annual CPR)	5		-	31		%	9		%
			Per loan annual cost to service	$	82	-	$	84		$	82

Guarantee asset	3,049		Discount rate	11		-	11		%	11		%
			Prepayment rate (annual CPR)	14		-	14		%	14		%

REO	1,725		Loss severity	4		-	39		%	18		%

Loan purchase commitments, net ⁽²⁾	2,121		MSR multiple	1.9		-	5.1		x	3.8		x
			Pull-through rate	13		-	100		%	72		%
			Whole loan spread to TBA price	$	2.13	-	$	3.10		$	3.07
			Whole loan spread to swap rate - fixed rate	180		-	270		bps	268		bps
			Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate - hybrid	100		-	190		bps	133		bps

Liabilities
ABS issued:⁽¹⁾	944,288		Discount rate	3		-	15		%	4		%
			Prepayment rate (annual CPR)	11		-	20		%	18		%
			Default rate	—		-	12		%	5		%
			Loss severity	20		-	32		%	26		%


(1)	The fair value of the loans held by consolidated Sequoia entities was based on the fair value of the ABS issued by these entities, which we determined were more readily observable, in accordance with accounting guidance for collateralized financing entities.


(2)	For the purpose of this presentation, loan purchase commitment assets and liabilities are presented net.

Determination of Fair Value

A description of the instruments measured at fair value as well as the general classification of such instruments pursuant to the Level 1, Level 2, and Level 3 valuation hierarchy is listed herein. We generally use both market comparable information and discounted cash flow modeling techniques to determine the fair value of our Level 3 assets and liabilities. Use of these techniques requires determination of relevant inputs and assumptions, some of which represent significant unobservable inputs as indicated in the preceding table. Accordingly, a significant increase or decrease in any of these inputs – such as anticipated credit losses, prepayment rates, interest rates, or other valuation assumptions – in isolation would likely result in a significantly lower or higher fair value measurement.

Residential loans at Redwood

Estimated fair values for residential loans are determined using models that incorporate various observable inputs, including pricing information from whole loan sales and securitizations. Certain significant inputs in these models are considered unobservable and are therefore Level 3 in nature. Pricing inputs obtained from market whole loan transaction activity include indicative spreads to indexed to be announced ("TBA") prices and indexed swap rates for fixed-rate loans and indexed swap rates for hybrid loans (Level 3). Pricing inputs obtained from market securitization activity include indicative spreads to indexed TBA prices for senior residential mortgage-backed securities ("RMBS") and indexed swap rates for subordinate RMBS, and credit support levels (Level 3). Other unobservable inputs also include assumed future prepayment rates. Observable inputs include benchmark interest rates, swap rates, and TBA prices. At September 30, 2017, our jumbo fixed-rate loans that were not committed to sell were priced using whole loan sale inputs. These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed, or credit support assumptions.

Residential loans at Consolidated Sequoia entities

We have elected to account for the consolidated Sequoia securitization entities as collateralized financing entities ("CFEs") in accordance with GAAP. A CFE is a variable interest entity that holds financial assets and issues beneficial interests in those assets, and these beneficial interests have contractual recourse only to the related assets of the CFE. Accounting guidance for CFEs allow companies to elect to measure both the financial assets and financial liabilities of a CFE using the more observable of the fair value of the financial assets or fair value of the financial liabilities. Pursuant to this guidance, we use the fair value of the ABS issued by the Sequoia CFEs (which we determined to be more observable) to determine the fair value of the loans held at these entities, whereby the net assets we consolidate in our financial statements related to these entities represent the estimated fair value of our retained interests in the Sequoia CFEs.

Real estate securities

Real estate securities include residential, commercial, and other asset-backed securities that are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators that are factored into the analysis include bid/ask spreads, the amount and timing of credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as a discount rate, prepayment rate, default rate, loss severity and credit support. The estimated fair value of our securities would generally decrease based upon an increase in default rates, serious delinquencies, or a decrease in prepayment rates or credit support.

As part of our securities valuation process, we request and consider indications of value from third-party securities dealers. For purposes of pricing our securities at September 30, 2017, we received dealer price indications on 73% of our securities, representing 81% of our carrying value. In the aggregate, our internal valuations of the securities for which we received dealer price indications were within 1% of the aggregate average dealer valuations. Once we receive the price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are required to estimate fair value.

Derivative assets and liabilities

Our derivative instruments include swaps, swaptions, TBAs, financial futures, and loan purchase commitments ("LPCs"). Fair values of derivative instruments are determined using quoted prices from active markets, when available, or from valuation models and are supported by valuations provided by dealers active in derivative markets. Fair values of TBAs and financial futures are generally obtained using quoted prices from active markets (Level 1). Our derivative valuation models for swaps and swaptions require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of certain inputs. Model inputs can generally be verified and model selection does not involve significant management judgment (Level 2).

LPC fair values for jumbo loans are estimated based on the estimated fair values of the underlying loans (as described in "Residential loans" above) as well as the probability that the mortgage loan will be purchased (the "Pull-through rate") (Level 3).

For other derivatives, valuations are based on various factors such as liquidity, bid/ask spreads, and credit considerations for which we rely on available market inputs. In the absence of such inputs, management’s best estimate is used (Level 3).

MSRs

MSRs include the rights to service jumbo and conforming residential mortgage loans. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Changes in the fair value of MSRs occur primarily due to the collection/realization of expected cash flows, as well as changes in valuation inputs and assumptions. Estimated fair values are based on applying the inputs to generate the net present value of estimated future MSR income (Level 3). These discounted cash flow models utilize certain significant unobservable inputs including market discount rates, assumed future prepayment rates of serviced loans, and the market cost of servicing. An increase in these unobservable inputs would generally reduce the estimated fair value of the MSRs.

As part of our MSR valuation process, we received a valuation estimate from a third-party valuations firm. In the aggregate, our internal valuation of the MSRs were within 2% of the third-party valuation.

FHLBC Stock

Our Federal Home Loan Bank ("FHLB") member subsidiary is required to purchase Federal Home Loan Bank of Chicago ("FHLBC") stock under a borrowing agreement between our FHLB-member subsidiary and the FHLBC. Under this agreement, the stock is redeemable at face value, which represents the carrying value and fair value of the stock (Level 2).

Guarantee Asset

The guarantee asset represents the estimated fair value of cash flows we are contractually entitled to receive related to a risk sharing arrangement with Fannie Mae. Significant inputs in the valuation analysis are Level 3, due to the nature of this asset and the lack of market quotes. The fair value of the guarantee asset is determined using a discounted cash flow model, for which significant unobservable inputs include assumed future prepayment rates and market discount rate (Level 3). An increase in prepayment rates or discount rate would generally reduce the estimated fair value of the guarantee asset.

Pledged Collateral

Pledged collateral consists of cash and U.S. Treasury securities held by a custodian in association with certain agreements we have entered into. Treasury securities are carried at their fair value, which is determined using quoted prices in active markets (Level 1).

Cash and cash equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values (Level 1).

Restricted cash

Restricted cash primarily includes interest-earning cash balances related to risk sharing transactions with the Agencies, cash held in association with borrowings from the FHLBC, and cash held at consolidated Sequoia entities for the purpose of distribution to investors and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values (Level 1).

Accrued interest receivable and payable

Accrued interest receivable and payable includes interest due on our assets and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values (Level 1).

REO

REO includes properties owned in satisfaction of foreclosed loans. Fair values are determined using available market quotes, appraisals, broker price opinions, comparable properties, or other indications of value (Level 3).

Margin receivable

Margin receivable reflects cash collateral we have posted with our various derivative and debt counterparties as required to satisfy margin requirements. Fair values approximate carrying values (Level 2).

Guarantee Obligations

In association with our risk sharing transactions with the Agencies, we have made certain guarantees. These obligations are initially recorded at fair value and subsequently carried at amortized cost. Fair values of guarantee obligations are determined using internal models that incorporate certain significant inputs that are considered unobservable and are therefore Level 3 in nature. Pricing inputs include assumed future prepayment rates, credit losses, and market discount rates. A decrease in future prepayment rates or discount rates, or an increase in credit losses, would generally cause the fair value of the guarantee obligations to decrease (become a larger liability).

Short-term debt

Short-term debt includes our credit facilities that mature within one year. As these borrowings are secured and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2). Additionally, at September 30, 2017, short-term debt included unsecured convertible senior notes with a maturity of less than one year. The fair value of the convertible notes is determined using quoted prices in generally active markets (Level 2).

ABS issued

ABS issued includes asset-backed securities issued through the Legacy Sequoia and Sequoia Choice securitization entities. These instruments are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. For ABS issued, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators factored into the analysis include bid/ask spreads, the amount and timing of collateral credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). A decrease in credit losses or discount rate, or an increase in prepayment rates, would generally cause the fair value of the ABS issued to decrease (become a larger liability).

FHLBC Borrowings

FHLBC borrowings include amounts borrowed from the FHLBC that are secured, generally by residential mortgage loans. As these borrowings are secured and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2).

Convertible notes

Convertible notes include unsecured convertible and exchangeable senior notes. Fair values are determined using quoted prices in generally active markets (Level 2).

Trust preferred securities and subordinated notes

Estimated fair values of trust preferred securities and subordinated notes are determined using discounted cash flow analysis valuation techniques. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3).