Quarterly report pursuant to Section 13 or 15(d)

Fair Value (Notes)

v2.4.0.6
Fair Value (Notes)
 9 Months Ended
Sep. 30, 2012
Fair Value [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 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 100.0% of its U.S. Treasuries as Level 1 fair value assets at September 30, 2012. The Company classified 100.0% of its RMBS AFS securities reported at fair value as Level 2 at September 30, 2012. AFS and trading securities account for 90.8% and 6.1% of all assets reported at fair value at September 30, 2012, respectively.
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 100% of its mortgage loans held-for-sale as Level 2 fair value assets at September 30, 2012.
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, 2012.
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 broker quotes to value these instruments. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at September 30, 2012. The Company reported 100% of its TBAs as Level 1 as of September 30, 2012.
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 are determined by a valuation model. The model inputs include interest rates in effect at the end of the period and fallout assumptions if the borrower elects not to close the loan. The model input for interest rates and fallout assumptions are generally observable and do not involve significant management judgment. The Company classified 100% of its forward purchase commitments at fair value as Level 2 at September 30, 2012.
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 the International Swap and Derivatives Association, or 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.
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, 2012
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$
—

 
$
14,969,859

 
$
—

 
$
14,969,859

Trading securities
1,002,461

 
—

 
—

 
1,002,461

Mortgage loans held-for-sale
—

 
14,553

 
—

 
14,553

Derivative assets
3,967

 
492,821

 
—

 
496,788

Total assets
$
1,006,428

 
$
15,477,233

 
$
—

 
$
16,483,661

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
—

 
$
132,322

 
$
—

 
$
132,322

Total liabilities
$
—

 
$
132,322

 
$
—

 
$
132,322

 
Recurring Fair Value Measurements
 
At December 31, 2011
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
Available-for-sale securities
$
—

 
$
6,238,136

 
$
11,116

 
$
6,249,252

Trading securities
1,003,301

 
—

 
—

 
1,003,301

Mortgage loans held-for-sale
—

 
—

 
5,782

 
5,782

Derivative assets
2,664

 
249,192

 
—

 
251,856

Total assets
$
1,005,965

 
$
6,487,328

 
$
16,898

 
$
7,510,191

Liabilities
 
 
 
 
 
 
 
Derivative liabilities
$
5,652

 
$
43,428

 
$
—

 
$
49,080

Total liabilities
$
5,652

 
$
43,428

 
$
—

 
$
49,080



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, 2012, 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, 2012
 
Nine Months Ended September 30, 2012
 
 
Assets
 
Assets
 
(in thousands)
Available-For-Sale Securities
 
Mortgage Loans Held-For-Sale
 
Available-For-Sale Securities
 
Mortgage Loans Held-For-Sale
 
Beginning of period level 3 fair value
$
—

 
$
—

 
$
11,116

 
$
5,782

 
Gains/(losses) included in net income:
 
 
 
 
 
 
 
 
Realized gains (losses)
—

 
—

 
—

 
—

 
Unrealized gains (losses)
—

 
—

 
—

 
(45
)
(1) 
Total net gains/(losses) included in net income
—

 
—

 
—

 
(45
)
 
Other comprehensive income 
—

 
—

 
—

 
—

 
Purchases
—

 
—

 
—

 
—

 
Sales
—

 
—

 
—

 
—

 
Settlements
—

 
—

 
—

 
(26
)
 
Gross transfers into level 3
—

 
—

 
—

 
—

 
Gross transfers out of level 3
—

 
—

 
(11,116
)
 
(5,711
)
 
End of period level 3 fair value
$
—

 
$
—

 
$
—

 
$
—

 
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period
$
—

 
$
—

 
$
—

 
$
—

 
___________________
(1)
For the nine months ended September 30, 2012 , the change in unrealized losses on mortgage loans held-for-sale was recorded in other income on the condensed consolidated statements of comprehensive income.

The Company transferred three Level 3 assets in the amount of $16.8 million into Level 2 during the nine months ended September 30, 2012. 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 three and nine months ended September 30, 2012. Transfers between Levels are deemed to take place on the first day of the reporting period in which the transfer has taken place.
Fair Value Option for Financial Assets and Financial Liabilities
The Company elected the fair value option for the residential mortgage loans it acquires. 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 other income on the condensed consolidated statements of comprehensive income. The fair value option is irrevocable once the loan is acquired.
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, 2012
 
Nine Months Ended September 30, 2012
(in thousands)
 
 
 
Interest income (1)
$
167

 
$
362

Realized loss on mortgage loans (2)
(23
)
 
(45
)
Unrealized gain on mortgage loans (2)
34

 
59

Total included in net income
$
178

 
$
376

Change in fair value due to credit risk
$
—

 
$
—

____________________
(1)
Interest income on mortgage loans held-for-sale 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 is recorded in other income 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.
 
September 30, 2012
 
December 31, 2011
(in thousands)
Unpaid Principal Balance
 
Fair Value (1)
 
Unpaid Principal Balance
 
Fair Value (1)
Mortgage loans held-for-sale
 
 
 
 
 
 
 
Total loans
$
14,156

 
$
14,553

 
$
5,655

 
$
5,782

Nonaccrual loans
$
—

 
$
—

 
$
—

 
$
—

Loans 90+ days past due
$
—

 
$
—

 
$
—

 
$
—

____________________
(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, mortgage loans held-for-sale, 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 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 $280.0 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.