Quarterly report pursuant to Section 13 or 15(d)

Fair Value

v3.22.2.2
Fair Value
9 Months Ended
Sep. 30, 2022
Fair Value Disclosures [Abstract]  
Fair Value Fair Value
Fair Value Measurements
ASC 820, Fair Value Measurements and Disclosures, or 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. The 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 98.7% and 1.3% of its AFS securities as Level 2 and Level 3 fair value assets, respectively, at September 30, 2022.
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 forecasted prepayment speeds, delinquency levels, option-adjusted spread, or OAS, 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 September 30, 2022.
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 and swaptions. The Company utilizes third-party brokers to value its financial derivative instruments. The Company did not hold any interest rate swaps or swaptions at September 30, 2022.
The Company may also enter into certain other derivative financial instruments, such as inverse interest-only securities, TBAs, futures and options on futures. The Company utilizes third-party pricing vendors to value inverse interest-only securities, as these instruments are similar in form to the Company’s AFS securities. The Company classified 100% of its inverse interest-only securities at fair value as Level 2 at September 30, 2022. TBAs, futures and options on futures are considered to be active markets such that participants transact with sufficient frequency and volume to provide transparent pricing information for identical instruments. The Company utilizes third-party pricing vendors to value TBAs, futures and options on futures. The Company reported 100% of its TBAs and futures as Level 1 as of September 30, 2022. The Company did not hold any options on futures at September 30, 2022.
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. Additionally, both the Company and the counterparty or clearing agency are required to post cash margin based upon the net underlying market value of the Company’s open positions with the counterparty. Posting of cash margin typically occurs daily, subject to certain dollar thresholds. Due to the existence of netting arrangements, as well as frequent cash margin 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
September 30, 2022
(in thousands) Level 1 Level 2 Level 3 Total
Assets:
Available-for-sale securities $ —  $ 9,348,983  $ 124,860  $ 9,473,843 
Mortgage servicing rights —  —  3,021,790  3,021,790 
Derivative assets 1,687  16,719  —  18,406 
Total assets $ 1,687  $ 9,365,702  $ 3,146,650  $ 12,514,039 
Liabilities:
Derivative liabilities $ 107,379  $ —  $ —  $ 107,379 
Total liabilities $ 107,379  $ —  $ —  $ 107,379 
Recurring Fair Value Measurements
December 31, 2021
(in thousands) Level 1 Level 2 Level 3 Total
Assets:
Available-for-sale securities $ —  $ 7,149,399  $ 12,304  $ 7,161,703 
Mortgage servicing rights —  —  2,191,578  2,191,578 
Derivative assets 38,767  41,367  —  80,134 
Total assets $ 38,767  $ 7,190,766  $ 2,203,882  $ 9,433,415 
Liabilities:
Derivative liabilities $ 1,915  $ 51,743  $ —  $ 53,658 
Total liabilities $ 1,915  $ 51,743  $ —  $ 53,658 
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 September 30, 2022, 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 swap and swaption agreements, are valued by the Company using observable inputs, specifically quotations received from third-party brokers. Exchange-traded derivative instruments, including futures and options on futures, are valued based on quoted prices for identical instruments in active markets.
The following table presents the reconciliation for the Company’s Level 3 assets measured at fair value on a recurring basis:
Three Months Ended Nine Months Ended
September 30, 2022 September 30, 2022
(in thousands) Available-For-Sale Securities Mortgage Servicing Rights Available-For-Sale Securities Mortgage Servicing Rights
Beginning of period level 3 fair value
$ 87,490  $ 3,226,191  $ 12,304  $ 2,191,578 
Gains (losses) included in net income:
Realized (36) (82,607) (1,309) (310,611)
Unrealized (5,272)
(1)
75,887 
(2)
(3,592)
(1)
800,072 
(2)
Reversal of provision for credit losses 50  —  1,177  — 
Net gains (losses) included in net income (5,258) (6,720) (3,724) 489,461 
Other comprehensive income 198  —  625  — 
Purchases 42,430  56,391  122,030  601,141 
Sales —  (258,563) (6,375) (258,563)
Settlements —  4,491  —  (1,827)
Gross transfers into level 3 —  —  —  — 
Gross transfers out of level 3 —  —  —  — 
End of period level 3 fair value $ 124,860  $ 3,021,790  $ 124,860  $ 3,021,790 
Change in unrealized gains or losses for the period included in earnings for assets held at the end of the reporting period
$ (5,272)
(3)
$ 85,374 
(4)
$ (4,495)
(3)
$ 712,252 
(4)
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
$ (5,073) $ —  $ (3,869) $ — 
____________________
(1)The change in unrealized gains or losses on available-for-sale securities accounted for under the fair value option was recorded in (loss) gain on investment securities on the condensed consolidated statements of comprehensive (loss) income.
(2)The change in unrealized gains or losses on MSR was recorded in (loss) gain on servicing asset on the condensed consolidated statements of comprehensive (loss) income.
(3)The change in unrealized gains or losses on available-for-sale securities accounted for under the fair value option that were held at the end of the reporting period was recorded in (loss) gain on investment securities on the condensed consolidated statements of comprehensive (loss) income.
(4)The change in unrealized gains or losses on MSR that were held at the end of the reporting period was recorded in (loss) gain on servicing asset on the condensed consolidated statements of comprehensive (loss) income.

No transfers between Level 1, Level 2 or Level 3 were made during the nine months ended September 30, 2022. 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 September 30, 2022 and December 31, 2021:
September 30, 2022
Valuation Technique Unobservable Input Range
Weighted Average (1)
Discounted cash flow Constant prepayment speed 6.3% - 7.4% 6.9%
Delinquency 0.7% - 0.7% 0.7%
Option-adjusted spread 4.9% - 8.2% 5.0%
Per loan annual cost to service $67.32 - $80.52 $67.71
December 31, 2021
Valuation Technique Unobservable Input Range
Weighted Average (1)
Discounted cash flow Constant prepayment speed 10.0% - 17.9% 12.9%
Delinquency 0.9% - 1.8% 1.3%
Option-adjusted spread 4.6% - 9.2% 4.7%
Per loan annual cost to service $66.04 - $83.91 $66.76
___________________
(1)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 and revolving credit facilities that mature in less than one year generally approximates fair value due to the short maturities. As of September 30, 2022, the Company had outstanding borrowings of $931.2 million under revolving credit facilities that are considered long-term. The Company’s long-term revolving credit facilities 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 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 September 30, 2022. 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 September 30, 2022 and December 31, 2021:
September 30, 2022 December 31, 2021
(in thousands) Carrying Value Fair Value Carrying Value Fair Value
Assets:
Available-for-sale securities $ 9,473,843  $ 9,473,843  $ 7,161,703  $ 7,161,703 
Mortgage servicing rights $ 3,021,790  $ 3,021,790  $ 2,191,578  $ 2,191,578 
Cash and cash equivalents $ 732,482  $ 732,482  $ 1,153,856  $ 1,153,856 
Restricted cash $ 842,534  $ 842,534  $ 934,814  $ 934,814 
Derivative assets $ 18,406  $ 18,406  $ 80,134  $ 80,134 
Reverse repurchase agreements $ 207,206  $ 207,206  $ 134,682  $ 134,682 
Other assets $ 3,254  $ 3,254  $ 3,332  $ 3,332 
Liabilities:
Repurchase agreements $ 10,034,018  $ 10,034,018  $ 7,656,445  $ 7,656,445 
Revolving credit facilities $ 1,131,161  $ 1,131,161  $ 420,761  $ 420,761 
Term notes payable $ 397,697  $ 377,625  $ 396,776  $ 395,030 
Convertible senior notes $ 282,096  $ 238,780  $ 424,827  $ 435,774 
Derivative liabilities $ 107,379  $ 107,379  $ 53,658  $ 53,658