TWO Quarterly report pursuant to Section 13 or 15(d)

Quarterly report pursuant to Section 13 or 15(d)

Fair Value (Notes)

Fair Value (Notes)

9 Months Ended

Sep. 30, 2013

Fair Value Measurements

ASC 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 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). Additionally, ASC 820 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 820 establishes a three level hierarchy to be used when measuring and disclosing fair value. An instrument’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. Following is a description of the three levels:


Level 1	Inputs are quoted prices in active markets for identical assets or liabilities as of the measurement date under current market conditions. Additionally, the entity must have the ability to access the active market and the quoted prices cannot be adjusted by the entity.


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 that are observable or can be corroborated by observable market data by correlation or other means for substantially the full-term of the assets or liabilities.


Level 3	Unobservable inputs are supported by little or no market activity. The unobservable inputs represent the assumptions that market participants would use to price the assets and liabilities, including risk. Generally, Level 3 assets and liabilities are valued using pricing models, discounted cash flow methodologies, or similar techniques that require significant judgment or estimation.

Following are descriptions of the valuation methodologies used to measure material assets and liabilities at fair value and details of the valuation models, key inputs to those models and significant assumptions utilized.

Investment securities - The Company holds a portfolio of AFS and trading securities that are carried at fair value in the condensed consolidated balance sheet. AFS securities are primarily comprised of Agency and non-Agency RMBS while the Company’s U.S. Treasuries are classified as trading securities. The Company determines the fair value of its U.S. Treasuries and Agency RMBS based upon prices obtained from third-party pricing providers or broker quotes received using bid price, which are deemed indicative of market activity. In determining the fair value of its non-Agency RMBS, management judgment is used to arrive at fair value that considers prices obtained from third-party pricing providers, broker quotes received and other applicable market data. If observable market prices are not available or insufficient to determine fair value due to principally illiquidity in the marketplace, then fair value is based upon internally developed models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels, and credit losses). The Company classified 100% of its U.S. Treasuries as Level 1 fair value assets at September 30, 2013. The Company classified 100% of its RMBS AFS securities reported at fair value as Level 2 at September 30, 2013. AFS and trading securities account for 81.2% and 6.4%, respectively, of all assets reported at fair value at September 30, 2013.

Equity securities - The Company held shares of Silver Bay common stock at December 31, 2012 that were carried at fair value in the condensed consolidated balance sheet as a result of a fair value option election. The Company determined fair value of these equity securities based on the closing market price at period end. Because the shares were distributed to the Company’s stockholders in 2013, equity securities are no longer recognized on the condensed consolidated balance sheet as of September 30, 2013.

Mortgage loans held-for-sale - The Company holds a portfolio of mortgage loans held-for-sale that are carried at fair value in the condensed consolidated balance sheet as a result of a fair value option election. The Company determines fair value of its mortgage loans based on prices obtained from third-party pricing providers and other applicable market data. If observable market prices are not available or insufficient to determine fair value due principally to illiquidity in the marketplace, then fair value is based upon cash flow models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels and credit losses). The Company classified 21.4% and 78.6% of its mortgage loans held-for-sale as Level 2 and Level 3 fair value assets, respectively, at September 30, 2013.

Mortgage loans held-for-investment in securitization trusts - The Company recognizes on its condensed consolidated balance sheet mortgage loans held-for-investment in securitization trusts that are carried at fair value as a result of a fair value option election. The Company determines fair value of its mortgage loans based on prices obtained from third-party pricing providers and other applicable market data. If observable market prices are not available or insufficient to determine fair value due principally to illiquidity in the marketplace, then fair value is based upon cash flow models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels and credit losses). The Company classified 100% of its mortgage loans held-for-investment in securitization trusts as Level 2 fair value assets at September 30, 2013.

Mortgage servicing rights - The Company holds a portfolio of MSRs that are carried at fair value and included in other assets on the condensed consolidated balance sheet. As there are limited MSR transactions that are directly observable in the market, the Company determines fair value of its MSRs based upon cash flow models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels and discount rates). The Company classified 100% of its MSRs as Level 3 fair value assets at September 30, 2013.

Derivative instruments - The Company may enter into a variety of derivative financial instruments as part of its hedging strategies. The Company principally executes over-the-counter, or OTC, derivative contracts, such as interest rate swaps, swaptions, and credit default swaps. The Company utilizes third-party pricing providers to value its financial derivative instruments. The Company classified 100% of the interest rate swaps, swaptions and credit default swaps reported at fair value as Level 2 at September 30, 2013.

The Company also enters into certain other derivative financial instruments, such as TBAs and inverse interest-only securities. These instruments are similar in form to the Company’s AFS securities and the Company utilizes a pricing service for TBAs and broker quotes for inverse interest-only securities to value these instruments. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at September 30, 2013. The Company reported 100% of its TBAs as Level 1 as of September 30, 2013.

The Company may also enter into forward purchase commitments on mortgage loans whereby the Company commits to purchasing the loans at a particular interest rate. The fair value of these derivatives is determined based on prices obtained from third-party price providers. Fallout assumptions if the borrower elects not to close the loan are applied to the third-party pricing. The Company did not hold any forward purchase commitments as of September 30, 2013.

The Company’s risk management committee governs trading activity relating to derivative instruments. The Company’s policy is to minimize credit exposure related to financial derivatives used for hedging by limiting the hedge counterparties to major banks, financial institutions, exchanges, and private investors who meet established capital and credit guidelines as well as by limiting the amount of exposure to any individual counterparty.

The Company has netting arrangements in place with all derivative counterparties pursuant to standard documentation developed by ISDA. Additionally, both the Company and the counterparty are required to post cash collateral based upon the net underlying market value of the Company’s open positions with the counterparty. Posting of cash collateral typically occurs daily, subject to certain dollar thresholds. Due to the existence of netting arrangements, as well as frequent cash collateral posting at low posting thresholds, credit exposure to the Company and/or to the counterparty is considered materially mitigated. Based on the Company’s assessment, there is no requirement for any additional adjustment to derivative valuations specifically for credit.

Collateralized borrowings in securitization trusts - The Company recognizes on its condensed consolidated balance sheet collateralized borrowings that are carried at fair value as a result of a fair value option election. The Company determines fair value of its collateralized borrowings based on prices obtained from third-party pricing providers, broker quotes received and other applicable market data. If observable market prices are not available or insufficient to determine fair value due to principally illiquidity in the marketplace, then fair value is based upon internally developed models that are primarily based on observable market-based inputs but also include unobservable market data inputs (including prepayment speeds, delinquency levels, and credit losses). The Company classified 100% of its collateralized borrowings in securitization trusts as Level 2 fair value assets at September 30, 2013.

The following tables display the Company’s assets and liabilities measured at fair value on a recurring basis. The Company often economically hedges the fair value change of its assets or liabilities with derivatives and other financial instruments. The tables below display the hedges separately from the hedged items, and therefore do not directly display the impact of the Company’s risk management activities.



	Recurring Fair Value Measurements
	At September 30, 2013
(in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale securities	$	—	$	12,672,233	$	—	$	12,672,233
Trading securities	1,000,625		—		—		1,000,625
Mortgage loans held-for-sale	—		119,607		440,130		559,737
Mortgage loans held-for-investment in securitization trusts	—		804,988		—		804,988
Derivative assets	21,896		522,619		—		544,515
Mortgage servicing rights	—		—		15,703		15,703
Total assets	$	1,022,521	$	14,119,447	$	455,833	$	15,597,801
Liabilities
Collateralized borrowings in securitization trusts	$	—	$	649,082	$	—	$	649,082
Derivative liabilities	34,634		39,193		—		73,827
Total liabilities	$	34,634	$	688,275	$	—	$	722,909



	Recurring Fair Value Measurements
	At December 31, 2012
(in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale securities	$	—	$	13,665,083	$	1,871	$	13,666,954
Trading securities	1,002,062		—		—		1,002,062
Equity securities	335,638		—		—		335,638
Mortgage loans held-for-sale	—		58,607		—		58,607
Derivative assets	1,917		460,163		—		462,080
Total assets	$	1,339,617	$	14,183,853	$	1,871	$	15,525,341
Liabilities
Derivative liabilities	$	239	$	129,055	$	—	$	129,294
Total liabilities	$	239	$	129,055	$	—	$	129,294

The Company may be required to measure certain assets or liabilities at fair value from time to time. These periodic fair value measures typically result from application of certain impairment measures under GAAP. These items would constitute nonrecurring fair value measures under ASC 820. As of September 30, 2013, the Company did not have any assets or liabilities measured at fair value on a nonrecurring basis in the periods presented.

The valuation of Level 3 instruments requires significant judgment by the third-party pricing providers and/or management. The third-party pricing providers and/or management rely on inputs such as market price quotations from market makers (either market or indicative levels), original transaction price, recent transactions in the same or similar instruments, and changes in financial ratios or cash flows to determine fair value. Level 3 instruments may also be discounted to reflect illiquidity and/or non-transferability, with the amount of such discount estimated by the third-party pricing provider in the absence of market information. Assumptions used by the third-party pricing provider due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s financial statements. The Company’s valuation committee reviews all valuations that are based on pricing information received from a third-party pricing provider. As part of this review, prices are compared against other pricing or input data points in the marketplace, along with internal valuation expertise, to ensure the pricing is reasonable. In addition, the Company performs back-testing of pricing information to validate price information and identify any pricing trends of a third-party price provider.

In determining fair value, third-party pricing providers use various valuation approaches, including market and income approaches. Inputs that are used in determining fair value of an instrument may include pricing information, credit data, volatility statistics, and other factors. In addition, inputs can be either observable or unobservable.

The availability of observable inputs can vary by instrument and is affected by a wide variety of factors, including the type of instrument, whether the instrument is new and not yet established in the marketplace and other characteristics particular to the instrument. The third-party pricing provider uses prices and inputs that are current as of the measurement date, including during periods of market dislocations. In periods of market dislocation, the availability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified to or from various levels within the fair value hierarchy.

Securities for which market quotations are readily available are valued at the bid price (in the case of long positions) or the ask price (in the case of short positions) at the close of trading on the date as of which value is determined. Exchange-traded securities for which no bid or ask price is available are valued at the last traded price. OTC derivative contracts, including interest rate swaps, swaptions, and credit default swaps, are valued by the Company using observable inputs, specifically quotations received from third-party pricing providers, and are therefore classified within Level 2.

The table below presents the reconciliation for all of the Company’s Level 3 assets and liabilities measured at fair value on a recurring basis. The Level 3 items presented below may be hedged by derivatives and other financial instruments that are classified as Level 1 or Level 2. Thus, the tables below do not fully reflect the impact of the Company’s risk management activities.



	Level 3 Recurring Fair Value Measurements
	Three Months Ended September 30, 2013
	Assets
(in thousands)	Available-For-Sale Securities			Mortgage Loans Held-For-Sale				Mortgage Servicing Rights
Beginning of period level 3 fair value	$	—		$	438,193			$	1,452
Gains/(losses) included in net income:
Realized gains (losses)	—		⁽¹⁾	211				—
Unrealized gains (losses)	—			7,588			⁽²⁾	861
Total net gains/(losses) included in net income	—			7,799				861
Other comprehensive income	—			—				—
Purchases	—			175				13,390
Sales	—			—				—
Settlements	—			(6,037		)		—
Gross transfers into level 3	—			—				—
Gross transfers out of level 3	—			—				—
End of period level 3 fair value	$	—		$	440,130			$	15,703
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period	$	—		$	7,588		⁽³⁾	$	861



	Level 3 Recurring Fair Value Measurements
	Nine Months Ended September 30, 2013
	Assets
(in thousands)	Available-For-Sale Securities				Mortgage Loans Held-For-Sale				Mortgage Servicing Rights
Beginning of period level 3 fair value	$	1,871			$	—			$	—
Gains/(losses) included in net income:
Realized gains (losses)	74			⁽¹⁾	633				—
Unrealized gains (losses)	—				8,762			⁽²⁾	816
Total net gains/(losses) included in net income	74				9,395				816
Other comprehensive income	1,426				—				—
Purchases	—				440,243				14,887
Sales	—				—				—
Settlements	—				(9,508		)		—
Gross transfers into level 3	3,000				—				—
Gross transfers out of level 3	(6,371		)		—				—
End of period level 3 fair value	$	—			$	440,130			$	15,703
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period	$	—			$	8,762		⁽³⁾	$	816

___________________


(1)	For the three and nine months ended September 30, 2013, the realized gains on available-for-sale securities represent net (premium amortization)/discount accretion recorded in interest income on the condensed consolidated statements of comprehensive income.


(2)	For the three and nine months ended September 30, 2013, the change in unrealized gains or losses on mortgage loans held-for-sale was recorded in (loss) gain on mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income.


(3)	For the three and nine months ended September 30, 2013, the change in unrealized gains or losses on mortgage loans held-for-sale that were held at the end of the reporting period were recorded in (loss) gain on mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income.

The Company transferred one Level 2 asset in the amount of $3.0 million into Level 3 during the three months ended March 31, 2013. The asset was deemed to be Level 3 based on the limited availability of third-party pricing. However, during the nine months ended September 30, 2013, the Company transferred this asset along with two other Level 3 assets in the amount of $6.4 million into Level 2. The assets were deemed to be Level 2 based on the availability of third-party pricing and corroborating market data. The Company did not incur transfers between Level 1 and Level 2 for the nine months ended September 30, 2013. Transfers between Levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.

The Company used a third-party pricing provider in the fair value measurement of its Level 3 mortgage loans held-for-sale. The significant unobservable inputs used by the third-party pricing provider included expected default, severity and discount rate. Significant increases (decreases) in any of the inputs in isolation may result in significantly lower (higher) fair value measurement.

The table below presents information about the significant unobservable inputs used in the fair value measurement of the Company’s MSRs classified as Level 3 fair value assets at September 30, 2013:



	As of September 30, 2013
(in thousands)	Fair Value		Valuation Technique	Unobservable Input ⁽¹⁾	Range				Weighted Average
Mortgage servicing rights	$	15,703	Discounted cash flow	Constant prepayment speed	6	-	11	%	8.5	%
				Delinquency	3	-	10	%	5.0	%
				Discount rate	8	-	14	%	11.3	%

___________________


(1)	Significant increases/(decreases) in any of the inputs in isolation may result in significantly lower/(higher) fair value measurement. A change in the assumption used for discount rates may be accompanied by a directionally similar change in the assumption used for the the probability of delinquency and a directionally opposite change in the assumption used for prepayment rates.

Fair Value Option for Financial Assets and Financial Liabilities

The Company elected the fair value option for the residential mortgage loans it acquired. The fair value option was elected to mitigate earnings volatility by better matching the accounting for the assets with the related hedges. The residential mortgage loans are carried within mortgage loans held-for-sale on the condensed consolidated balance sheet. The Company’s policy is to separately record interest income on these fair value elected loans. Upfront fees and costs related to the fair value elected loans are not deferred or capitalized. Fair value adjustments are reported in (loss) gain on mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income. The fair value option is irrevocable once the loan is acquired.

The Company elected the fair value option for the equity securities carried on the condensed consolidated balance sheet at December 31, 2012, which consist solely of shares of Silver Bay common stock. The Company determined fair value of these equity securities based on the closing market price at period end. Fair value adjustments are reported in (loss) gain on investment securities on the condensed consolidated statements of comprehensive income.

The Company also elected the fair value option for both the mortgage loans held-for-investment in securitization trusts and the collateralized borrowings in securitization trusts carried on the condensed consolidated balance sheet. The fair value option was elected to better reflect the economics of the Company’s retained interests. The Company’s policy is to separately record interest income on the fair value elected loans and interest expense on the fair value elected borrowings. Upfront fees and costs are not deferred or capitalized. Fair value adjustments are reported in other income on the condensed consolidated statements of comprehensive income.

The following table summarizes the fair value option elections and information regarding the amounts recognized in earnings for each fair value option-elected item.



	Changes included in the Condensed Consolidated Statements of Comprehensive Income
	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
(in thousands)
Interest income:
Interest income on mortgage loans held-for-sale ⁽¹⁾	$	9,297		$	167		$	15,409		$	362
Interest income on mortgage loans held-for-investment in securitization trusts⁽¹⁾	5,649			—			11,672			—
Interest expense:
Interest expense on collateralized borrowings in securitization trusts	(3,125		)	—			(6,112		)	—
Other income:
Realized loss on mortgage loans held-for-sale⁽²⁾	(10,456		)	(23		)	(10,221		)	(45		)
Unrealized gain on mortgage loans held-for-sale ⁽²⁾	6,013			34			4,974			59
Unrealized gain (loss) on mortgage loans held-for-investment in securitization trusts⁽³⁾	1,698			—			(23,059		)	—
Unrealized gain on collateralized borrowings in securitization trusts⁽³⁾	7,076			—			39,680			—
Realized gain on equity securities ⁽⁴⁾	—			—			13,725			—
Unrealized loss on equity securities ⁽⁴⁾	—			—			(5,882		)	—
Total included in net income	$	16,152		$	178		$	40,186		$	376
Change in fair value due to credit risk	$	—		$	—		$	—		$	—

____________________


(1)	Interest income on mortgage loans held-for-sale and mortgage loans held-for-investment in securitization trusts is measured by multiplying the unpaid principal balance on the loans by the coupon rate and the number of days of interest due.


(2)	Realized loss and unrealized gain on mortgage loans held-for-sale are recorded in (loss) gain on mortgage loans held-for-sale on the condensed consolidated statements of comprehensive income.


(3)	Unrealized gain (loss) on mortgage loans held-for-investment in securitization trusts and unrealized gain on collateralized borrowings in securitization trusts are recorded in other income on the condensed consolidated statements of comprehensive income.


(4)	Realized gain and unrealized loss on equity securities are recorded in (loss) gain on investment securities on the condensed consolidated statements of comprehensive income.

The table below provides the fair value and the unpaid principal balance for the Company’s fair value option-elected loans and collateralized borrowings.



	September 30, 2013				December 31, 2012
(in thousands)	Unpaid Principal Balance		Fair Value ⁽¹⁾		Unpaid Principal Balance		Fair Value ⁽¹⁾
Mortgage loans held-for-sale
Total loans	$	688,620	$	559,737	$	56,976	$	58,607
Nonaccrual loans	$	70,382	$	55,782	$	—	$	—
Loans 90+ days past due	$	47,086	$	37,303	$	—	$	—
Mortgage loans held-for-investment in securitization trusts
Total loans	$	825,285	$	804,988	$	—	$	—
Nonaccrual loans	$	—	$	—	$	—	$	—
Loans 90+ days past due	$	—	$	—	$	—	$	—
Collateralized borrowings in securitization trusts
Total borrowings	$	698,150	$	649,082	$	—	$	—

____________________


(1)	Excludes accrued interest receivable.

Fair Value of Financial Instruments

In accordance with ASC 820, the Company is required to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the condensed consolidated balance sheet, for which fair value can be estimated.

The following describes the Company’s methods for estimating the fair value for financial instruments. Descriptions are not provided for those items that have zero balances as of the current balance sheet date.

•

AFS securities, trading securities, equity securities, mortgage loans held-for-sale, mortgage loans held-for-investment in securitization trusts, MSRs, derivative assets and liabilities, and collateralized borrowings in securitization trusts are recurring fair value measurements; carrying value equals fair value. See discussion of valuation methods and assumptions within the Fair Value Measurements section of this footnote.


•	Cash and cash equivalents and restricted cash have a carrying value which approximates fair value because of the short maturities of these instruments. The Company categorizes the fair value measurement of these assets as Level 1.

•

The carrying value of repurchase agreements that mature in less than one year generally approximates fair value due to the short maturities. The Company holds $200.0 million of repurchase agreements that are considered long-term. The Company’s long-term repurchase agreements have floating rates based on an index plus a spread and the credit spread is typically consistent with those demanded in the market. Accordingly, the interest rates on these borrowings are at market and thus carrying value approximates fair value. The Company categorizes the fair value measurement of these liabilities as Level 1.

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, 2013 and December 31, 2012.



	September 30, 2013				December 31, 2012
(in thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Available-for-sale securities	$	12,672,233	$	12,672,233	$	13,666,954	$	13,666,954
Trading securities	1,000,625		1,000,625		1,002,062		1,002,062
Equity securities	—		—		335,638		335,638
Mortgage loans held-for-sale	559,737		559,737		58,607		58,607
Mortgage loans held-for-investment in securitization trusts	804,988		804,988		—		—
Cash and cash equivalents	723,160		723,160		821,108		821,108
Restricted cash	678,328		678,328		302,322		302,322
Derivative assets	544,515		544,515		462,080		462,080
Mortgage servicing rights	15,703		15,703		—		—
Liabilities
Repurchase agreements	$	12,152,065	$	12,152,065	$	12,624,510	$	12,624,510
Collateralized borrowings in securitization trusts	649,082		649,082		—		—
Derivative liabilities	73,827		73,827		129,294		129,294

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

+ References + Details