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 December 31, 2018 and December 31, 2017.

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



	December 31, 2018				December 31, 2017
	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	$	1,048,690	$	1,048,690	$	1,427,052	$	1,427,052
At lower of cost or fair value	111		131		893		993
Residential loans, held-for-investment	6,205,941		6,205,941		3,687,265		3,687,265
Business purpose residential loans	141,258		141,258		—		—
Multifamily loans	2,144,598		2,144,598		—		—
Trading securities	1,118,612		1,118,612		968,844		968,844
Available-for-sale securities	333,882		333,882		507,666		507,666
Servicer advance investments ⁽¹⁾	300,468		300,468		—		—
MSRs ⁽¹⁾	60,281		60,281		63,598		63,598
Participation in loan warehouse facility ⁽¹⁾	39,703		39,703		—		—
Excess MSRs ⁽¹⁾	27,312		27,312		—		—
Cash and cash equivalents	175,764		175,764		144,663		144,663
Restricted cash	29,313		29,313		2,144		2,144
Accrued interest receivable	47,105		47,105		27,013		27,013
Derivative assets	35,789		35,789		15,718		15,718
REO ⁽²⁾	3,943		4,396		3,354		3,806
Margin receivable⁽²⁾	100,773		100,773		85,044		85,044
FHLBC stock ⁽²⁾	43,393		43,393		43,393		43,393
Guarantee asset⁽²⁾	2,618		2,618		2,869		2,869
Pledged collateral⁽²⁾	42,433		42,433		42,615		42,615
Liabilities
Short-term debt facilities	$	1,937,920	$	1,937,920	$	1,688,412	$	1,688,412
Short-term debt - servicer advance financing	262,740		262,740		—		—
Accrued interest payable	42,528		42,528		18,435		18,435
Margin payable ⁽³⁾	835		835		390		390
Guarantee obligation ⁽³⁾	16,711		16,774		19,487		18,878
Derivative liabilities	84,855		84,855		63,081		63,081
ABS issued at fair value	5,410,073		5,410,073		1,164,585		1,164,585
FHLBC long-term borrowings	1,999,999		1,999,999		1,999,999		1,999,999
Convertible notes, net	633,196		618,271		686,759		692,369
Trust preferred securities and subordinated notes, net	138,582		102,533		138,535		103,230


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


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


(3)	These liabilities are included in Accrued expenses and other liabilities on our consolidated balance sheets.

During the years ended December 31, 2018 and 2017, we elected the fair value option for $109 million and $47 million of residential senior securities, $545 million and $594 million of subordinate securities, and $8.38 billion and $5.64 billion of residential loans (principal balance). Additionally, during the year ended December 31, 2018, we elected the fair value option for $168 million of business purpose residential loans (principal balance), $2.13 billion of multifamily loans (principal balance), $396 million of servicer advance investments, and $25 million of excess MSRs. We anticipate electing the fair value option for all future purchases of residential loans that we intend to sell to third parties or transfer to securitizations, as well as for business purpose 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 December 31, 2018 and December 31, 2017, 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



December 31, 2018	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	7,254,631	$	—	$	—	$	7,254,631
Business purpose residential loans	141,258		—		—		141,258
Multifamily loans	2,144,598		—		—		2,144,598
Trading securities	1,118,612		—		—		1,118,612
Available-for-sale securities	333,882		—		—		333,882
Servicer advance investments	300,468		—		—		300,468
MSRs	60,281		—		—		60,281
Excess MSRs	27,312		—		—		27,312
Derivative assets	35,789		4,665		28,211		2,913
Pledged collateral	42,433		42,433		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	2,618		—		—		2,618

Liabilities
Derivative liabilities	$	84,855	$	13,215	$	70,908	$	732
ABS issued	5,410,073		—		—		5,410,073



December 31, 2017	Carrying Value		Fair Value Measurements Using
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3
Assets
Residential loans	$	5,114,317	$	—	$	—	$	5,114,317
Trading securities	968,844		—		—		968,844
Available-for-sale securities	507,666		—		—		507,666
Derivative assets	15,718		134		10,164		5,420
MSRs	63,598		—		—		63,598
Pledged collateral	42,615		42,615		—		—
FHLBC stock	43,393		—		43,393		—
Guarantee asset	2,869		—		—		2,869

Liabilities
Derivative liabilities	$	63,081	$	3,808	$	55,567	$	3,706
ABS issued	1,164,585		—		—		1,164,585

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the years ended December 31, 2018 and December 31, 2017.

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



	Assets
	Residential Loans			Business Purpose Residential Loans			Multifamily Loans			Trading Securities			AFS Securities			Servicer Advance Investments			MSRs			Excess MSRs		Guarantee Asset
(In Thousands)	Residential Loans			Business Purpose Residential Loans			Multifamily Loans			Trading Securities			AFS Securities			Servicer Advance Investments			MSRs			Excess MSRs		Guarantee Asset
Beginning balance - December 31, 2017	$	5,114,317		$	—		$	—		$	968,844		$	507,666		$	—		$	63,598		$	—	$	2,869
Acquisitions	8,338,724			167,777			2,099,916			653,739			7,739			395,813			328			25,489		—
Sales	(5,425,168		)	—			—			(438,304		)	(143,644		)	—			(1,077		)	—		—
Principal paydowns	(814,122		)	(27,382		)	(1,873		)	(40,050		)	(44,446		)	(94,644		)	—			—		—
Gains (losses) in net income, net	44,627			863			46,555			(8,436		)	41,051			(701		)	(2,568		)	1,823		(251		)
Unrealized losses in OCI, net	—			—			—			—			(34,484		)	—			—			—		—
Other settlements, net⁽²⁾	(3,747		)	—			—			(17,181		)	—			—			—			—		—
Ending balance - December 31, 2018	$	7,254,631		$	141,258		$	2,144,598		$	1,118,612		$	333,882		$	300,468		$	60,281		$	27,312	$	2,618

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



				Liabilities
	Derivatives ⁽¹⁾			ABS Issued
(In Thousands)	Derivatives ⁽¹⁾			ABS Issued
Beginning balance - December 31, 2017	$	1,714		$	1,164,585
Acquisitions	—			4,613,168
Principal paydowns	—			(459,173		)
Gains (losses) in net income, net	(1,214		)	91,493
Other settlements, net⁽²⁾	1,681			—
Ending balance - December 31, 2018	$	2,181		$	5,410,073



	Assets																		Liabilities
(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	5,741,427			640,760			39,700			8,026			—			—			567,099
Sales	(3,982,683		)	(137,886		)	(90,440		)	(52,788		)	—			—			—
Principal paydowns	(573,168		)	(19,224		)	(58,554		)	—			—			—			(205,163		)
Gains (losses) in net income, net	46,119			39,507			31,892			(10,166		)	(1,223		)	37,220			29,187
Unrealized gains in OCI, net	—			—			12,316			—			—			—			—
Other settlements, net ⁽²⁾	(4,223		)	—			—			—			—			(35,020		)	—
Ending balance - December 31, 2017	$	5,114,317		$	968,844		$	507,666		$	63,598		$	2,869		$	1,714		$	1,164,585


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

(2)

Other settlements, net for residential loans represents the transfer of loans to REO, and for derivatives, the settlement of forward sale commitments and the transfer of the fair value of loan purchase commitments at the time loans are acquired to the basis of residential loans. Other settlements, net for our trading securities relates to the consolidation of the Freddie Mac K-Series entities during the second half of 2018.

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 December 31, 2018, 2017, and 2016. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the years ended December 31, 2018, 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 December 31, 2018, 2017, and 2016 Included in Net Income



	Included in Net Income
	Years Ended December 31,
(In Thousands)	2018			2017			2016
Assets
Residential loans at Redwood	$	(17,757	)	$	523		$	(17,370	)
Residential loans at consolidated Sequoia entities	24,799			17,727			(14,391		)
Residential loans at consolidated Freddie Mac SLST entity	21,295			—			—
Business purpose residential loans	445			—			—
Multifamily loans at consolidated Freddie Mac K-Series entities	46,555			—			—
Trading securities	(12,256		)	28,612			7,184
Available-for-sale securities	(89		)	(1,011		)	(368		)
Servicer advance investments	(702		)	—			—
MSRs	1,942			1,277			42,964
Excess MSRs	1,824			—			—
Loan purchase commitments	2,913			3,243			—
Loan forward sale commitments	—			2,177			—
Other assets - Guarantee asset	(251		)	(1,223		)	(1,605		)

Liabilities
Loan purchase commitments	$	(732	)	$	(3,706	)	$	(486	)
ABS issued	(71,468		)	(29,187		)	8,275

The following table presents information on assets recorded at fair value on a non-recurring basis at December 31, 2018 and December 31, 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 sheets at December 31, 2018 and December 31, 2017.

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



									Gain (Loss) for Year Ended
December 31, 2018	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		December 31, 2018
Assets
REO	$	2,225	$	—	$	—	$	2,225	$	(131	)

									Gain (Loss) for Year Ended
December 31, 2017	Carrying Value		Fair Value Measurements Using						Gain (Loss) for Year Ended
(In Thousands)	Carrying Value		Level 1		Level 2		Level 3		December 31, 2017
Assets
Residential loans, at lower of cost or fair value	$	854	$	—	$	—	$	854	$	22
REO	2,034		—		—		2,034		(393		)

The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the years ended December 31, 2018, 2017, and 2016.

Table 5.6 – Market Valuation Gains and Losses, Net



	Years Ended December 31,
(In Thousands)	2018			2017			2016
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value	$	23,144		$	31,493		$	5,786
Single-family rental loans held-for-sale, at fair value	453			—			—
Residential loan purchase and forward sale commitments	(1,336		)	37,880			25,613
Commercial loans, at fair value	—			—			433
Sequoia securities	—			—			1,455
Risk management derivatives, net	34,739			(17,529		)	3,158
Total mortgage banking activities, net ⁽¹⁾	$	57,000		$	51,844		$	36,445
Investment Fair Value Changes, Net
Residential loans held-for-investment at Redwood	$	(29,573	)	$	(5,765	)	$	(23,102	)
Residential bridge loans held-for-investment	(29		)	—			—
Trading securities	(8,055		)	39,526			9,666
Commercial loans held-for-sale	—			300			(307		)
Servicer advance investments	(701		)	—			—
Excess MSRs	1,823			—			—
Net investments in Legacy Sequoia entities ⁽²⁾	(1,016		)	(8,027		)	(4,200		)
Net investments in Sequoia Choice entities ⁽²⁾	443			(323		)	—
Net investment in Freddie Mac SLST entity ⁽²⁾	1,271			—			—
Net investments in Freddie Mac K-Series entities ⁽²⁾	931			—			—
Risk-sharing investments	(434		)	(1,484		)	(1,151		)
Risk management derivatives, net	9,740			(12,842		)	(9,112		)
Impairments on AFS securities	(89		)	(1,011		)	(368		)
Total investment fair value changes, net	$	(25,689	)	$	10,374		$	(28,574	)
Other Income, Net
MSRs	$	(2,508	)	$	(10,166	)	$	(36,372	)
Risk management derivatives, net	(4,734		)	(568		)	15,584
Total other income, net ⁽³⁾	$	(7,242	)	$	(10,734	)	$	(20,788	)
Total Market Valuation Gains (Losses), Net	$	24,069		$	51,484		$	(12,917	)


(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-investment, 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)	Other income, net presented above does not include net MSR fee income or provisions for repurchases for MSRs, as these amounts do not represent market valuation adjustments.

Valuation Policy

We maintain policies that specify the methodologies we use to value different types of financial instruments. Significant changes to the valuation methodologies are reviewed by members of senior management to confirm the changes are appropriate and reasonable. Valuations based on information from external sources are performed on an instrument-by-instrument basis with the resulting amounts analyzed individually against internal calculations as well as in the aggregate by product type classification. Initial valuations are performed by our portfolio management groups using the valuation processes described below. Our finance department then independently reviews all fair value estimates using available market, portfolio, and industry information to ensure they are reasonable. Finally, members of senior management review all fair value estimates, including an analysis of the methodology and valuation changes from prior reporting periods.

Valuation Process

We estimate fair values for financial assets or liabilities based on available inputs observed in the marketplace as well as unobservable inputs. We primarily use two pricing valuation techniques: market comparable pricing and discounted cash flow analysis. Market comparable pricing is used to determine the estimated fair value of certain instruments by incorporating known inputs and performance metrics, such as observed prepayment rates, delinquencies, severities, credit support, recent transaction prices, pending transactions, or prices of other similar instruments. Discounted cash flow analysis techniques generally consist of developing an estimate of future cash flows that are expected to occur over the life of an instrument and then discounting those cash flows at a rate of return that results in an estimate of fair value. After considering all available indications of the appropriate rate of return that market participants would require, we consider the reasonableness of the range indicated by the results to determine an estimate that is most representative of fair value. We also consider counterparty credit quality and risk as part of our fair value assessments.

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



December 31, 2018	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	$	2,738,346	Whole loan spread to TBA price	$	1.89	-	$	2.52		$	2.21
			Whole loan spread to swap rate	70		-	220		bps	200		bps

Jumbo hybrid loans	396,274		Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate	50		-	125		bps	86		bps

Jumbo loans committed to sell	298,002		Whole loan committed sales price	$	100.69	-	$	101.66		$	100.70

Loans held by Legacy Sequoia ⁽¹⁾	519,958		Liability price				N/A			N/A

Loans held by Sequoia Choice ⁽¹⁾	2,079,382		Liability price				N/A			N/A

Loans held by Freddie Mac SLST	1,222,669		Liability price				N/A			N/A

Business purpose residential loans:
Single-family rental loans	28,460		IO discount rate	12		-	12		%	12		%
			Prepayment rate (annual CPR)	2		-	10		%	3		%
			Senior credit spread	115		-	115		bps	115		bps
			Subordinate credit spread	165		-	994		bps	302		bps
			Senior credit support	32		-	32		%	32		%

Residential bridge loans	112,798		Discount rate	7			8		%	7		%

Multifamily loans held by Freddie Mac K-Series ⁽¹⁾	2,144,598		Liability price				N/A			N/A

Trading and AFS securities	1,452,494		Discount rate	3		-	14		%	6		%
			Prepayment rate (annual CPR)	—		-	60		%	10		%
			Default rate	—		-	27		%	2		%
			Loss severity	—		-	40		%	21		%

Servicer advance investments	300,468		Discount rate	5		-	5		%	5		%
			Prepayment rate (annual CPR)	8		-	16		%	14		%
			Expected remaining life ⁽²⁾	1		-	1		year	1		year
			Mortgage servicing amount	7		-	14		bps	10		bps

MSRs	60,281		Discount rate	11		-	29		%	11		%
			Prepayment rate (annual CPR)	4		-	29		%	7		%
			Per loan annual cost to service	$	82	-	$	82		$	82

Excess MSRs	27,312		Discount rate	12		-	19		%	17		%
			Prepayment rate (annual CPR)	8		-	15		%	11		%
			Excess mortgage servicing amount	7		-	18		bps	11		bps

Guarantee asset	2,618		Discount rate	11		-	11		%	11		%
			Prepayment rate (annual CPR)	8		-	8		%	8		%

REO	2,225		Loss severity	2		-	50		%	18		%

Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments (continued)



December 31, 2018	Fair Value			Input Values
(Dollars in Thousands, except Input Values)	Fair Value		Unobservable Input	Range						Weighted Average
Assets (continued)
Loan purchase commitments, net	$	2,181	MSR multiple	0.8		-	4.9		x	2.7		x
			Pull-through rate	10		-	98		%	69		%
			Whole loan spread to TBA price	$	1.89	-	$	2.52		$	2.51
			Whole loan spread to swap rate - fixed rate	70		-	220		bps	198		bps
			Prepayment rate (annual CPR)	15		-	15		%	15		%
			Whole loan spread to swap rate - hybrid	60		-	100		bps	77		bps
Liabilities
ABS issued ⁽¹⁾
At consolidated Sequoia entities	2,397,250		Discount rate	4		-	15		%	4		%
			Prepayment rate (annual CPR)	8		-	50		%	18		%
			Default rate	—		-	14		%	2		%
			Loss severity	20		-	44		%	21		%

At consolidated Freddie Mac SLST entity	993,748		Discount rate	3		-	4		%	3		%
			Prepayment rate (annual CPR)	6		-	6		%	6		%
			Default rate	2		-	2		%	2		%
			Loss severity	30		-	30		%	30		%

At consolidated Freddie Mac K-Series entities	2,019,075		Discount rate	3		-	9		%	3		%
			Prepayment rate (annual CPR)	—		-	—		%	—		%
			Default rate	1		-	1		%	1		%
			Loss severity	20		-	20		%	20		%


(1)	The fair value of the loans held by consolidated 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)	Represents the estimated average duration of outstanding servicer advances at a given point in time (not taking into account new advances made with respect to the pool).

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 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 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. These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed, or credit support assumptions.

Residential and multifamily loans at consolidated entities

We have elected to account for our consolidated securitization entities as collateralized financing entities 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 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 CFEs.

Business purpose residential loans

Business purpose residential loans include single-family rental loans and residential bridge loans 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.

Prices for our single-family rental loans are determined using market comparable information. Significant inputs obtained from market activity include indicative spreads to indexed swap rates for senior and subordinate MBS, IO MBS discount rates, senior credit support levels, and assumed future prepayment rates (Level 3). These assets would generally decrease in value based upon an increase in the credit spread or prepayment speed assumptions.

Prices for our residential bridge loans are determined using discounted cash flow modeling, which incorporates a primary significant unobservable input of discount rate. These assets would generally decrease in value based upon an increase in the discount rate.

Real estate securities

Real estate securities include residential, multifamily, and other mortgage-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 and loss severity. The estimated fair value of our securities would generally decrease based upon an increase in discount rate, default rates, loss severities, or a decrease in prepayment rates.

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 December 31, 2018, we received dealer price indications on 85% of our securities, representing 93% 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, loan purchase commitments, and forward sale commitments. 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 and FSC fair values for residential jumbo and single-family rental loans are estimated based on the estimated fair values of the underlying loans (as described in "Residential loans at Redwood" and "Business Purpose Residential Loans" above). In addition, fair values for LPCs are estimated based on 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).

Servicer advance investments

Estimated fair values for servicer advance investments are determined through internal pricing models that estimate future cash flows and utilize certain significant inputs that are considered unobservable and are therefore Level 3 in nature. Our estimations of cash flows include the combined cash flows of all of the components that comprise the servicer advance investments: existing advances, the requirement to purchase future advances, the recovery of advances, and the right to a portion of the associated mortgage servicing fee. The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included prepayment rate (of the loans underlying the investments), mortgage servicing amount (the amount of underlying servicing income expected to be received), servicer advance WAL (the weighted-average expected remaining life of servicer advances), and discount rate. These assets would generally decrease in value based upon an increase in prepayment rates, an increase in servicer advance WAL, or an increase in discount rate, or a decrease in mortgage servicing amount.

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.

Excess MSRs

Estimated fair values for excess MSRs are determined through internal pricing models that estimate future cash flows and utilize certain significant inputs that are considered unobservable and are therefore Level 3 in nature. The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included prepayment rate (of the loans underlying the investments), excess mortgage servicing amount (the amount of excess servicing income expected to be received), and discount rate. These assets would generally decrease in value based upon an increase in prepayment rates or discount rate, or a decrease in excess mortgage servicing amount.

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, cash held at Servicing Investment entities, 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).

Real estate owned

Real estate owned ("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).

Short-term debt

Short-term debt includes our credit facilities for residential and business purpose residential loans and real estate securities as well as non-recourse short-term borrowings used to finance servicer advance investments. 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).

ABS issued

ABS issued includes asset-backed securities issued through the Legacy Sequoia and Sequoia Choice securitization entities, as well as securities issued by certain third-party Freddie Mac K-Series and SLST securitization entities which we consolidate. 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). These cash flow models use significant unobservable inputs such as a discount rate, prepayment rate, default rate, loss severity and credit support. A decrease in credit losses or discount rates, or an increase in prepayment rates, would generally cause the fair value of the ABS issued to decrease (i.e., 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).

Financial Instruments Carried at Amortized Cost

Participation in loan warehouse facility

Our participation in a loan warehouse facility is carried at amortized cost (Level 2).

Guarantee obligations

In association with our risk-sharing transactions with the Agencies, we have made certain guarantees which are carried on our balance sheet at amortized cost (Level 3).

Convertible notes

Convertible notes include unsecured convertible and exchangeable senior notes that are carried at their unpaid principal balance net of any unamortized deferred issuance costs. The fair value of the convertible notes is determined using quoted prices in generally active markets (Level 2).

Trust preferred securities and subordinated notes

Trust preferred securities and subordinated notes are carried at their unpaid principal balance net of any unamortized deferred issuance costs (Level 3).