Quarterly report pursuant to Section 13 or 15(d)

Fair Value

v3.20.2
Fair Value
 6 Months Ended
Jun. 30, 2020
Fair Value Disclosures [Abstract]  
Fair Value Fair Value
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 1Inputs 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 2Inputs 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 3Unobservable 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.

The 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.
Available-for-sale securities. The Company holds a portfolio of AFS securities that are carried at fair value in the condensed consolidated balance sheets and primarily comprised of Agency RMBS and non-Agency securities. The Company determines the fair value of its Agency RMBS based upon prices obtained from third-party brokers and pricing vendors received using bid price, which are deemed indicative of market activity. The third-party pricing vendors use pricing models that generally incorporate such factors as coupons, primary and secondary mortgage rates, rate reset period, issuer, prepayment speeds, credit enhancements and expected life of the security. In determining the fair value of its non-Agency securities, management judgment may be used to arrive at fair value that considers prices obtained from third-party pricing vendors 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 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 99.98% and 0.02% of its AFS securities as Level 2 and Level 3 fair value assets, respectively, at June 30, 2020. AFS securities account for 92.7% of all assets reported at fair value at June 30, 2020.
Mortgage servicing rights. The Company holds a portfolio of MSR that are carried at fair value on the condensed consolidated balance sheets. The Company determines fair value of its MSR based on prices obtained from third-party pricing vendors. Although MSR transactions may be observable in the marketplace, the details of those transactions are not necessarily reflective of the value of the Company’s MSR portfolio. Third-party vendors use both observable market data and unobservable market data (including prepayment speeds, delinquency levels, discount rates and cost to service) as inputs into models, which help to inform their best estimates of fair value market price. As a result, the Company classified 100% of its MSR as Level 3 fair value assets at June 30, 2020.
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, caps, swaptions, put and call options for TBAs and Markit IOS total return swaps. The Company utilizes third-party brokers to value its financial derivative instruments. The Company classified 100% of the interest rate swaps reported at fair value as Level 2 at June 30, 2020. The Company did not hold any interest rate caps, swaptions, put and call options for TBAs or Markit IOS total return swaps at June 30, 2020.
The Company may also enter into certain other derivative financial instruments, such as TBAs, short U.S. Treasuries, U.S. Treasury futures and inverse interest-only securities. These instruments are similar in form to the Company’s AFS securities and the Company utilizes third-party vendors to value TBAs, short U.S. Treasuries, U.S. Treasury futures and inverse interest-only securities. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at June 30, 2020. The Company reported 100% of its TBAs as Level 1 as of June 30, 2020. The Company did not hold any short U.S. Treasuries or U.S. Treasury futures at June 30, 2020.
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, or central clearing exchange agreements, in the case of centrally cleared interest rate swaps. Additionally, both the Company and the counterparty or clearing agency 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 or clearing agency is considered materially mitigated. Based on the Company’s assessment, there is no requirement for any additional adjustment to derivative valuations specifically for credit.
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
June 30, 2020
(in thousands) Level 1 Level 2 Level 3 Total
Assets
Available-for-sale securities $ —    $ 17,669,429    $ 3,860    $ 17,673,289   
Mortgage servicing rights —    —    1,279,195    1,279,195   
Derivative assets 37,705    72,822    —    110,527   
Total assets $ 37,705    $ 17,742,251    $ 1,283,055    $ 19,063,011   
Liabilities
Derivative liabilities $ 1,298    $ —    $ —    $ 1,298   
Total liabilities $ 1,298    $ —    $ —    $ 1,298   
Recurring Fair Value Measurements
December 31, 2019
(in thousands) Level 1 Level 2 Level 3 Total
Assets
Available-for-sale securities $ —    $ 31,157,154    $ 249,174    $ 31,406,328   
Mortgage servicing rights —    —    1,909,444    1,909,444   
Derivative assets 8,513    179,538    —    188,051   
Total assets $ 8,513    $ 31,336,692    $ 2,158,618    $ 33,503,823   
Liabilities
Derivative liabilities $ 6,711    $ 29    $ —    $ 6,740   
Total liabilities $ 6,711    $ 29    $ —    $ 6,740   
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 U.S. GAAP. These items would constitute nonrecurring fair value measures under ASC 820. As of June 30, 2020, 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 vendors and/or management. The third-party pricing vendors 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 vendors in the absence of market information. Assumptions used by the third-party pricing vendors due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s condensed consolidated financial statements.
The Company’s valuation committee reviews all valuations that are based on pricing information received from third-party pricing vendors. 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 pricing vendors.
In determining fair value, third-party pricing vendors 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 vendor 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 that are priced using third-party broker quotations 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, caps and swaption agreements, put and call options for TBAs and U.S. Treasuries, constant maturity swaps, credit default swaps, U.S. Treasury futures and Markit IOS total return swaps, are valued by the Company using observable inputs, specifically quotations received from third-party brokers.
The following tables present the reconciliation for the Company’s Level 3 assets measured at fair value on a recurring basis:
Three Months Ended Six Months Ended
June 30, 2020 June 30, 2020
(in thousands) Available-For-Sale Securities Mortgage Servicing Rights Available-For-Sale Securities Mortgage Servicing Rights
Beginning of period level 3 fair value
 $ —    $ 1,505,163    $ 249,174    $ 1,909,444   
Gains (losses) included in net loss:
Realized (losses) gains, net (292)   (128,790)   (4,391)   (218,424)  
Unrealized (losses) gains, net —    (110,001)  
(1)
 —    (607,032)  
(1)
Provision for credit losses (896)   —    (896)   —   
Net gains (losses) included in net loss (1,188)   (238,791)   (5,287)   (825,456)  
Other comprehensive income (loss) 583    —    (24,338)   —   
Purchases —    21,551    —    205,334   
Sales —    381    (214,673)   1,814   
Settlements —    (9,109)   —    (11,941)  
Gross transfers into level 3 4,465    —    4,465    —   
Gross transfers out of level 3 —    —    (5,481)   —   
End of period level 3 fair value $ 3,860    $ 1,279,195    $ 3,860    $ 1,279,195   
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period
 $ —    $ (104,129)  
(2)
 $ —    $ (552,303)  
(2)
Change in unrealized gains or losses for the period included in other comprehensive (loss) income for assets held at the end of the reporting period
 $ 583    $ —    $ 583    $ —   
____________________
(1)The change in unrealized gains or losses on MSR was recorded in loss on servicing asset on the condensed consolidated statements of comprehensive income (loss).
(2)The change in unrealized gains or losses on MSR that were held at the end of the reporting period was recorded in loss on servicing asset on the condensed consolidated statements of comprehensive income (loss).

The Company transferred certain AFS securities from Level 2 to Level 3 and from Level 3 to Level 2 based the observability of inputs during the six months ended June 30, 2020. No additional AFS securities transfers between Level 1, Level 2 or Level 3 were made during the six months ended June 30, 2020. 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 multiple third-party pricing vendors in the fair value measurement of its Level 3 AFS securities. The significant unobservable inputs used by the third-party pricing vendors 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 Company also used multiple third-party pricing vendors in the fair value measurement of its Level 3 MSR. The tables below present information about the significant unobservable market data used by the third-party pricing vendors as inputs into models utilized to inform their best estimates of the fair value measurement of the Company’s MSR classified as Level 3 fair value assets at June 30, 2020 and December 31, 2019:
June 30, 2020
Valuation Technique
Unobservable Input (1)
Range
Weighted Average (2)
Discounted cash flow Constant prepayment speed 14.8 - 25.6 % 21.2%
Delinquency 1.5 - 2.5 % 2.2%
Discount rate 4.7 - 7.5 % 5.1%
Per loan annual cost to service $64.82 - $80.31 $68.50
December 31, 2019
Valuation Technique
Unobservable Input (1)
Range
Weighted Average (2)
Discounted cash flow Constant prepayment speed 12.6 - 16.4 % 14.8%
Delinquency 0.7 - 1.0 % 0.9%
Discount rate 6.4 - 7.8 % 7.2%
Per loan annual cost to service $63.38 - $78.04 $66.62
___________________
(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 probability of delinquency and a directionally opposite change in the assumption used for prepayment rates.
(2)Calculated by averaging the weighted average significant unobservable inputs used by the multiple third-party pricing vendors in the fair value measurement of MSR.

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 sheets, for which fair value can be estimated.
The following describes the Company’s methods for estimating the fair value for financial instruments.
•AFS securities, MSR, and derivative assets and liabilities 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 Note 10.
•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.
•Reverse repurchase agreements have a carrying value which approximates fair value due to their short-term nature. The Company categorizes the fair value measurement of these assets as Level 2.
•The carrying value of repurchase agreements, FHLB advances and revolving credit facilities that mature in less than one year generally approximates fair value due to the short maturities. The Company categorizes the fair value measurement of these liabilities as Level 2.
•Term notes payable are recorded at outstanding principal balance, net of any unamortized deferred debt issuance costs. In determining the fair value of term notes payable, management judgment may be used to arrive at fair value that considers prices obtained from third-party pricing vendors, broker quotes received 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 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 categorizes the fair value measurement of these liabilities as Level 2.
•Convertible senior notes are carried at their unpaid principal balance, net of any unamortized deferred issuance costs. The Company estimates the fair value of its convertible senior notes using the market transaction price nearest to June 30, 2020. The Company categorizes the fair value measurement of these assets as Level 2.
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 June 30, 2020 and December 31, 2019:
June 30, 2020 December 31, 2019
(in thousands) Carrying Value Fair Value Carrying Value Fair Value
Assets
Available-for-sale securities $ 17,673,289    $ 17,673,289    $ 31,406,328    $ 31,406,328   
Mortgage servicing rights $ 1,279,195    $ 1,279,195    $ 1,909,444    $ 1,909,444   
Cash and cash equivalents $ 1,615,639    $ 1,615,639    $ 558,136    $ 558,136   
Restricted cash $ 434,644    $ 434,644    $ 1,058,690    $ 1,058,690   
Derivative assets $ 110,527    $ 110,527    $ 188,051    $ 188,051   
Reverse repurchase agreements $ 76,416    $ 76,416    $ 220,000    $ 220,000   
Other assets $ 13,292    $ 13,292    24,352    24,352   
Liabilities
Repurchase agreements $ 16,991,248    $ 16,991,248    $ 29,147,463    $ 29,147,463   
Federal Home Loan Bank advances $ —    $ —    $ 210,000    $ 210,000   
Revolving credit facilities $ 267,181    $ 267,181    $ 300,000    $ 300,000   
Term notes payable $ 395,048    $ 340,000    $ 394,502    $ 400,000   
Convertible senior notes $ 285,515    $ 282,245    $ 284,954    $ 299,147   
Derivative liabilities $ 1,298    $ 1,298    $ 6,740    $ 6,740