Quarterly report pursuant to Section 13 or 15(d)

FAIR VALUE OF FINANCIAL INSTRUMENTS

v2.4.0.8
FAIR VALUE OF FINANCIAL INSTRUMENTS
9 Months Ended
Sep. 30, 2013
Fair Value Of Financial Instruments  
FAIR VALUE OF FINANCIAL INSTRUMENTS
9.     FAIR VALUE OF FINANCIAL INSTRUMENTS
 
U.S. GAAP requires the categorization of the fair value of financial instruments into three broad levels which form a hierarchy.
 
Level 1- Quoted prices in active markets for identical instruments.
 
Level 2- Valuations based principally on other observable market parameters, including
 
 
Quoted prices in active markets for similar instruments,
 
 
Quoted prices in less active or inactive markets for identical or similar instruments,

 
Other observable inputs (such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates), and

 
Market corroborated inputs (derived principally from or corroborated by observable market data).
 
Level 3- Valuations based significantly on unobservable inputs.
 
New Residential follows this hierarchy for its financial instruments. The classifications are based on the lowest level of input that is significant to the fair value measurement.
 
The carrying value and fair value of New Residential’s financial assets recorded at fair value on a recurring basis at September 30, 2013 were as follows:

               
Fair Value
 
   
Principal Balance or Notional Amount
   
Carrying Value
   
Level 2
   
Level 3
   
Total
 
Assets:
                             
Real estate securities, available-for-sale
  $ 2,054,797     $ 1,861,200     $ 1,279,450     $ 581,750     $ 1,861,200  
Investments in excess mortgage servicing rights, at fair value (A)
    72,315,805       307,568             307,568       307,568  
Investments in excess mortgage servicing rights, equity method investees, at fair value (A)
    169,856,996       358,032             358,032       358,032  
    $ 244,227,598     $ 2,526,800     $ 1,279,450     $ 1,247,350     $ 2,526,800  

(A)
The notional amount represents the total unpaid principal balance of the mortgage loans underlying the Excess MSRs. New Residential does not receive an excess mortgage servicing amount on nonperforming loans in Agency portfolios.
 
Investments in Excess MSRs Valuation
 
Fair value estimates of New Residential’s Excess MSRs were based on internal pricing models. The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included expectations of prepayment rates, delinquency rates, recapture rates, the excess mortgage servicing amount of the underlying mortgage loans and discount rates that market participants would use in determining the fair values of mortgage servicing rights on similar pools of residential mortgage loans. New Residential’s management validates significant inputs and outputs of the internal pricing models by comparing them to available independent third party market parameters and models for reasonableness. New Residential believes its valuation methods and the assumptions used are appropriate and consistent with other market participants.

In order to evaluate the reasonableness of its fair value determinations, management engages an independent valuation firm to separately measure the fair value of its Excess MSRs. The independent valuation firm determines an estimated fair value range of each pool based on its own models and issues a “fairness opinion” with this range. Management compares the range included in the opinion to the value generated by its internal models. For Excess MSRs acquired prior to the current quarter, the fairness opinion relates to the valuation at the current quarter end date. For Excess MSRs acquired during the current quarter, the fairness opinion relates to the valuation at the time of acquisition. To date, New Residential has not made any significant valuation adjustments as a result of these fairness opinions.
 
For Excess MSRs acquired during the current quarter, New Residential revalues the Excess MSRs at the quarter end date if a payment is received between the acquisition date and the end of the quarter. Otherwise, Excess MSRs acquired during the current quarter are carried at their amortized cost basis if there has been no change in assumptions since acquisition.
 
In addition, in valuing the Excess MSRs, management considered the likelihood of Nationstar being removed as the servicer, which likelihood is considered to be remote. Fair value measurements of the Excess MSRs are sensitive to changes in the assumptions or methodology used to determine fair value, and such changes could result in a significant increase or decrease in the fair value. Significant increases (decreases) in the discount rates, prepayment or delinquency rates in isolation would result in a significantly lower (higher) fair value measurement, whereas significant increases (decreases) in the recapture rates or excess mortgage servicing amount in isolation would result in a significantly higher (lower) fair value measurement. Generally, a change in the delinquency rate assumption is accompanied by a directionally similar change in the assumption used for the prepayment speed.
 
The following table summarizes certain information regarding the inputs used in valuing the Excess MSRs owned directly and through equity method investees as of September 30, 2013:

   
Significant Inputs
 
Held Directly (Note 3)
 
Prepayment Speed
(A)
   
Delinquency
(B)
   
Recapture Rate 
(C)
   
Excess Mortgage Servicing Amount (D)
 
Discount Rate
 
MSR Pool 1
    14.4 %     10.0 %     35.0 %  
28 bps
    12.5 %
MSR Pool 1 - Recapture Agreement
    8.0 %     10.0 %     35.0 %  
21 bps
    12.5 %
MSR Pool 2
    14.7 %     10.3 %     35.0 %  
23 bps
    12.5 %
MSR Pool 2 - Recapture Agreement
    8.0 %     5.0 %     35.0 %  
21 bps
    12.5 %
MSR Pool 3
    15.2 %     11.9 %     35.0 %  
24 bps
    12.5 %
MSR Pool 3 - Recapture Agreement
    8.0 %     10.0 %     35.0 %  
21 bps
    12.5 %
MSR Pool 4
    15.4 %     14.9 %     35.0 %  
17 bps
    12.5 %
MSR Pool 4 - Recapture Agreement
    8.0 %     10.0 %     35.0 %  
21 bps
    12.5 %
MSR Pool 5
    12.3 %     N/A (E)     14.0 %  
13 bps
    12.7 %
MSR Pool 5 - Recapture Agreement
    8.0 %     N/A (E)     15.0 %  
21 bps
    12.7 %
MSR Pool 11 - Recapture Agreement
    9.3 %     2.3 %     32.0 %  
19 bps
    12.5 %
MSR Pool 12
    15.3 %     N/A (E)     16.7 %  
26 bps
    16.4 %
MSR Pool 12 - Recapture Agreement
    7.0 %     N/A (E)     35.0 %  
19 bps
    16.4 %
                                     
Held through Equity Method Investees (Note 6)
                                   
MSR Pool 6
    18.2 %     8.9 %     35.0 %  
25 bps
    12.5 %
MSR Pool 6 - Recapture Agreement
    10.0 %     6.0 %     35.0 %  
23 bps
    12.5 %
MSR Pool 7
    13.3 %     8.0 %     35.0 %  
16 bps
    12.5 %
MSR Pool 7 - Recapture Agreement
    10.0 %     5.0 %     35.0 %  
19 bps
    12.5 %
MSR Pool 8
    14.3 %     6.9 %     35.0 %  
19 bps
    12.5 %
MSR Pool 8 - Recapture Agreement
    10.0 %     5.0 %     35.0 %  
19 bps
    12.5 %
MSR Pool 9
    18.0 %     5.0 %     35.0 %  
22 bps
    12.5 %
MSR Pool 9 - Recapture Agreement
    10.0 %     5.0 %     35.0 %  
28 bps
    12.5 %
MSR Pool 10
    11.5 %     N/A (E)     15.0 %  
12 bps
    12.7 %
MSR Pool 10 - Recapture Agreement
    9.0 %     N/A (E)     35.0 %  
19 bps
    12.7 %
MSR Pool 11
    18.7 %     7.8 %     38.9 %  
15 bps
    12.5 %
MSR Pool 11 - Recapture Agreement
    10.0 %     2.0 %     35.0 %  
19 bps
    12.5 %

(A)
Projected annualized weighted average lifetime voluntary and involuntary prepayment rate using a prepayment vector.
   
(B)
Projected percentage of mortgage loans in the pool that will miss their mortgage payments.
   
(C)
Percentage of voluntarily prepaid loans that are expected to be refinanced by Nationstar.
   
(D)
Weighted average total mortgage servicing amount in excess of the basic fee.
   
(E)
The Excess MSR will be paid on the total UPB of the mortgage portfolio (including both performing and delinquent loans until REO).
 
All of the assumptions listed have some degree of market observability, based on New Residential’s knowledge of the market, relationships with market participants, and use of common market data sources. Prepayment speed and delinquency rate projections are in the form of “curves” or “vectors” that vary over the expected life of the pool. New Residential uses assumptions that generate its best estimate of future cash flows for each investment in Excess MSRs.
 
When valuing Excess MSRs, New Residential uses the following criteria to determine the significant inputs:
 
 
Prepayment Speed: Prepayment speed projections are in the form of a “vector” that varies over the expected life of the pool. The prepayment vector specifies the percentage of the collateral balance that is expected to prepay voluntarily (i.e., pay off) and involuntarily (i.e., default) at each point in the future. The prepayment vector is based on assumptions that reflect factors such as the borrower’s FICO score, loan-to-value ratio, debt-to-income ratio, vintage on a loan level basis, as well as the projected effect on loans eligible for the Home Affordable Refinance Program 2.0 (“HARP 2.0”). Management considers collateral-specific prepayment experience when determining this vector. For the Recapture Agreements and recaptured loans, New Residential also considers industry research on the prepayment experience of similar loan pools (i.e., loan pools composed of refinanced loans). This data is obtained from remittance reports, market data services and other market sources.
     
 
Delinquency Rates: For existing mortgage pools, delinquency rates are based on the recent pool-specific experience of loans that missed their latest mortgage payments. For the Recapture Agreements and recaptured loans, delinquency rates are based on the experience of similar loan pools originated by Nationstar and delinquency experience over the past year. Management believes this time period provides a reasonable sample for projecting future delinquency rates while taking into account current market conditions. Additional consideration is given to loans that are expected to become 30 or more days delinquent.
 
 
Recapture Rates: Recapture rates are based on actual average recapture rates experienced by Nationstar on similar mortgage loan pools. Generally, New Residential looks to one year worth of actual recapture rates, which management believes provides a reasonable sample for projecting future recapture rates while taking into account current market conditions.
 
 
Excess Mortgage Servicing Amount: For existing mortgage pools, excess mortgage servicing amount projections are based on the actual total mortgage servicing amount in excess of a basic fee. For loans expected to be refinanced by Nationstar and subject to a Recapture Agreement, New Residential considers the excess mortgage servicing amount on loans recently originated by Nationstar over the past year and other general market considerations. Management believes this time period provides a reasonable sample for projecting future excess mortgage servicing amounts while taking into account current market conditions.
 
 
Discount Rate: The discount rates used by New Residential are derived from market data on pricing of mortgage servicing rights backed by similar collateral.

New Residential uses different prepayment and delinquency assumptions in valuing the Excess MSRs relating to the original loan pools, the Recapture Agreements and the Excess MSRs relating to recaptured loans. The prepayment speed and delinquency rate assumptions differ because of differences in the collateral characteristics, eligibility for the Home Affordable Refinance Program 2.0 (“HARP 2.0”) and expected borrower behavior for original loans and loans which have been refinanced. New Residential uses the same assumptions for recapture and discount rates when valuing Excess MSRs and Recapture Agreements. These assumptions are based on historical recapture experience and market pricing.

Excess MSRs, owned directly, measured at fair value on a recurring basis using Level 3 inputs changed during the nine months ended September 30, 2013 as follows:
 
   
Level 3 (A)
 
   
MSR Pool 1
   
MSR Pool 2
   
MSR Pool 3
   
MSR Pool 4
   
MSR Pool 5
   
MSR Pool 11
   
MSR Pool 12
   
Total
 
Balance at December 31, 2012
  $ 40,910     $ 39,322     $ 35,434     $ 15,036     $ 114,334     $     $     $ 245,036  
Transfers (B)
                                                             
Transfers from Level 3 (B)
                                               
Transfers to Level 3 (B)
                                               
Gains (losses) included in net income (C)
    6,807       7,509       7,657       3,644       18,208             74       43,899  
Interest income
    5,097       3,739       4,892       2,034       14,728             51       30,541  
Purchases, sales and repayments
                                                             
Purchases
                            26,637       2,391       17,393       46,421  
Purchase adjustments
                                               
Proceeds from sales
                                               
Proceeds from repayments
    (10,278 )     (9,096 )     (8,689 )     (3,525 )     (26,741 )                 (58,329 )
Balance at September 30, 2013
  $ 42,536     $ 41,474     $ 39,294     $ 17,189     $ 147,166     $ 2,391     $ 17,518     $ 307,568  

(A)
Includes the Recapture Agreement for each respective pool.
   
(B)
Transfers are assumed to occur at the beginning of the respective period.
   
(C)
The gains (losses) recorded in earnings during the period are attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates. These gains (losses) represent the change in fair value of the Excess MSRs and are recorded in “Change in fair value of investments in excess mortgage servicing rights” in the consolidated statements of income.

Excess Mortgage Servicing Rights Equity Method Investees Valuation

Fair value estimates of New Residential’s investments were based on internal pricing models. New Residential estimated the fair value of the assets and liabilities of the underlying entities in which it holds an equity interest. The valuation technique is based on discounted cash flows. Significant inputs represent the inputs required to estimate the fair value of the Excess MSRs held by the entities and include expectations of prepayment rates, delinquency rates, recapture rates, the excess mortgage servicing amount of the underlying mortgage loans, and discount rates that market participants would use in determining the fair values of mortgage servicing rights on similar pools of residential mortgage loans. In addition, in valuing the Excess MSRs, management considered the likelihood of Nationstar being removed as servicer, which likelihood is considered to be remote. Refer to the Investments in Excess MSRs Valuation section above for further details.
 
New Residential’s investments in equity method investees measured at fair value on a recurring basis using Level 3 inputs changed during the nine months ended September 30, 2013 as follows:
 
       
       
   
Nine Months Ended
 September 30, 2013
 
Balance at December 31, 2012
  $  
Contributions to equity method investees
    351,937  
Distributions of earnings from equity method investees
    (18,626 )
Distributions of capital from equity method investees
    (17,020 )
Change in fair value of investments in equity method investees
    41,741  
Balance at September 30, 2013
  $ 358,032  

Real Estate Securities Valuation
 
As of September 30, 2013, New Residential’s securities valuation methodology and results are further detailed as follows:
 
               
Fair Value
 
Asset Type
 
Outstanding Face Amount
   
Amortized Cost Basis
   
Multiple Quotes (A)
   
Total
   
Level
 
                               
Agency ARM RMBS
  $ 1,203,293     $ 1,285,532     $ 1,279,450     $ 1,279,450       2  
Non-Agency RMBS
    851,504       559,980       581,750       581,750       3  
                                         
Total
  $ 2,054,797     $ 1,845,512     $ 1,861,200     $ 1,861,200          
 
(A)
Management generally obtained pricing service quotations or broker quotations from two sources, one of which was generally the seller (the party that sold New Residential the security) for Non-Agency RMBS. Management selected one of the quotes received as being most representative of the fair value and did not use an average of the quotes. Even if New Residential receives two or more quotes on a particular security that come from non-selling brokers or pricing services, it does not use an average because management believes using an actual quote more closely represents a transactable price for the security than an average level. Furthermore, in some cases there is a wide disparity between the quotes New Residential receives. Management believes using an average of the quotes in these cases would not represent the fair value of the asset. Based on New Residential’s own fair value analysis, management selects one of the quotes which is believed to more accurately reflect fair value. New Residential never adjusts quotes received. These quotations are generally received via email and contain disclaimers which state that they are “indicative” and not “actionable” — meaning that the party giving the quotation is not bound to actually purchase the security at the quoted price.
 
Fair value measurements categorized within Level 3 are sensitive to changes in the assumptions or methodology used to determine fair value, and such changes could result in a significant increase or decrease in the fair value. For New Residential’s investments in real estate securities categorized within Level 3 of the fair value hierarchy, the significant unobservable inputs include the discount rates, assumptions related to prepayments, default rates and loss severities. Significant increases (decreases) in any of the discount rates, default rates or loss severities in isolation would result in a significantly lower (higher) fair value measurement. The impact of changes in prepayment speeds would have differing impacts on fair value, depending on the seniority of the investment. Generally, a change in the default assumption is accompanied by directionally similar changes in the assumptions used for the loss severity and the prepayment speed.
 
Fair value estimates of New Residential’s Non-Agency RMBS were based on third party indications as of September 30, 2013 and classified as Level 3. Securities measured at fair value on a recurring basis using Level 3 inputs changed during the nine months ended September 30, 2013 as follows:
 
   
Level 3
 
   
Non-Agency
 
   
RMBS
 
       
Balance at December 31, 2012
  $ 289,756  
Transfer (A)
       
Transfers from Level 3
     
Transfers into Level 3
     
         
Total gains (losses)
       
Included in net income as impairment
    (729 )
Gain on settlement of securities
    11,271  
Included in comprehensive income (B)
    6,501  
         
Amortization included in interest income
    16,286  
Purchases, sales and repayments
       
Purchases
    450,144  
Sales
    (123,130 )
Proceeds from repayments
    (68,349 )
         
Balance at September 30, 2013
  $ 581,750  
 
(A)
Transfers are assumed to occur at the beginning of the respective period.
   
(B)
These gains (losses) were included in net unrealized gain (loss) on securities in the consolidated statements of comprehensive income.
 
Loans for Which Fair Value is Only Disclosed
 
As of September 30, 2013, loans which New Residential has the intent and ability to hold into the foreseeable future are classified as held-for-investment. Loans held-for-investment are carried at the aggregate unpaid principal balance adjusted for any unamortized premium or discount, deferred fees or expenses, an allowance for loan losses, charge-offs and write-downs for impaired loans.
 
The fair value of New Residential’s reverse mortgage loans held-for-investment were estimated based on a discounted cash flow analysis using internal pricing models. The significant inputs to these models include discount rates and the timing and amount of expected cash flows that management believes market participants would use in determining the fair values on similar pools of reverse mortgage loans. New Residential’s loans held-for-investment are categorized within Level 3 of the fair value hierarchy.
 
The following table summarizes the inputs used in valuing reverse mortgage loans as of September 30, 2013:

Reverse Mortgage Loans for Which Fair Value is Only Disclosed
 
                           
Significant Inputs
 
Loan Type
 
Outstanding Face Amount (A)
   
Carrying Value (A)
   
Fair Value
   
Valuation Allowance/ (Reversal) In Current Year
   
Discount Rate
   
Weighted Average Life (Years) (B)
 
                                     
Reverse Mortgage Loans
  $ 56,738     $ 33,060     $ 33,162     $       10.3 %     3.8  
 
(A) Represents a 70% interest New Residential holds in the reverse mortgage loans. 
   
(B)
The weighted average life is based on the expected timing of the receipt of cash flows.

Liabilities for Which Fair Value is Only Disclosed

Repurchase agreements are not measured at fair value in the statement of position; however, management believes that their carrying value approximates fair value. Repurchase agreements are considered to be Level 2 in the valuation hierarchy with significant valuation variables including the amount and timing of expected cash flows, interest rates and collateral funding spreads.