Edgar Filing: FLAGSTAR BANCORP INC

FBC 2012.09.30 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012



¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 001-16577

(Exact name of registrant as specified in its charter).



Michigan		38-3150651
(State or other jurisdiction of		(I.R.S. Employer
Incorporation or organization)		Identification No.)

5151 Corporate Drive, Troy, Michigan		48098-2639
(Address of principal executive offices)		(Zip code)

(248) 312-2000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past ninety days. Yes ý No ¨.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):



Large accelerated filer	¨	Accelerated filer	ý
Non-accelerated filer	o (Do not check if smaller reporting company)	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No ý.

As of October 25, 2012, 55,833,109 shares of the registrant’s common stock, $0.01 par value, were issued and outstanding.

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FORWARD – LOOKING STATEMENTS

This report contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. Forward-looking statements, by their nature, involve estimates, projections, goals, forecasts, assumptions, risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in a forward-looking statement. Examples of forward-looking statements include statements regarding our expectations, beliefs, plans, goals, objectives and future financial or other performance. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and variations of such words and similar expressions are intended to identify such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made. Except to fulfill our obligations under the U.S. securities laws, we undertake no obligation to update any such statement to reflect events or circumstances after the date on which it is made.

There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include:


(1)	Volatile interest rates that impact, amongst other things, (i) the mortgage banking business, (ii) our ability to originate loans and sell assets at a profit, (iii) prepayment speeds and (iv) our cost of funds, could adversely affect earnings, growth opportunities and our ability to pay dividends to stockholders;


(2)	Competitive factors for loans could negatively impact gain on loan sale margins;


(3)	Competition from banking and non-banking companies for deposits and loans can affect our growth opportunities, earnings, gain on sale margins, market share and ability to transform business model;


(4)	Changes in the regulation of financial services companies and government-sponsored housing enterprises, and in particular, declines in the liquidity of the residential mortgage loan secondary market, could adversely affect our business;


(5)	Changes in regulatory capital requirements or an inability to achieve or maintain desired capital ratios could adversely affect our growth and earnings opportunities and our ability to originate certain types of loans, as well as our ability to sell certain types of assets for fair market value or to transform business model;


(6)	General business and economic conditions, including unemployment rates, movements in interest rates, the slope of the yield curve, any increase in fraud and other related criminal activity and the further decline of asset values in certain geographic markets, may significantly affect our business activities, loan losses, reserves, earnings and business prospects;


(7)	Factors concerning the implementation of proposed refinements and transformation of our business model could result in slower implementation times than we anticipate and negate any competitive advantage that we may enjoy;


(8)	Actions of mortgage loan purchasers, guarantors and insurers regarding repurchases and indemnity demands and uncertainty related to foreclosure procedures could adversely affect our business activities and earnings;

(9)

The Dodd-Frank Wall Street Reform and Consumer Protection Act has resulted in the elimination of the Office of Thrift Supervision (the "OTS"), tightening of capital standards, and the creation of a new Consumer Financial Protection Bureau and has resulted, or will result, in new laws, regulations and regulatory supervisors that are expected to increase our costs of operations. In addition, the change to the Office of the Comptroller of the Currency (the "OCC") as our primary federal regulator may result in interpretations, or in OCC enforcement actions, different than those of the OTS and may affect our operations and our relationships with institutional counterparties;


(10)	Both the volume and the nature of consumer actions and other forms of litigation against financial institutions have increased and to the extent that such actions are brought against us or threatened, the cost of defending such suits as well as potential exposure could increase our costs of operations;


(11)	Our compliance with the terms and conditions of the agreement with the U.S. Department of Justice, the impact of performance and enforcement of commitments under, and provisions contained in the

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agreement, and our accuracy and ability to estimate the financial impact of that agreement, including the fair value of the future payments required, could accelerate our litigation settlement expenses relating thereto;


(12)	Our compliance with the terms and conditions of the Consent Order with the OCC;


(13)	The downgrade by Standards & Poor's of the long-term credit rating of the U.S. could materially affect global and domestic financial markets and economic conditions, which may affect our business activities, financial condition, and liquidity;


(14)	If we do not regain compliance with the New York Stock Exchange (“NYSE”) continued listing requirements, our common stock may be delisted from the NYSE (the stock price deficiency is deemed cured if it promptly exceeds $1.00 per share after October 11, 2012, the date of the reverse split, and remains above that level for at least the following 30 trading days); and


(15)	Our potential loss of key personnel or our inability to attract and retain qualified personnel in the future could affect our ability to operate effectively.

All of the above factors are difficult to predict, contain uncertainties that may materially affect actual results, and may be beyond our control. New factors emerge from time to time, and it is not possible for our management to predict all such factors or to assess the effect of each such factor on our business.

Please also refer to Item 1A to Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 and Item 1A to Part II of this Quarterly Report on Form 10-Q, which are incorporated by reference herein, for further information on these and other factors affecting us.

Although we believe that these forward-looking statements are based on reasonable, estimates and assumptions, they are not guarantees of future performance and are subject to known and unknown risks, uncertainties, contingencies and other factors. Accordingly, we cannot give you any assurance that our expectations will in fact occur or that actual results will not differ materially from those expressed or implied by such forward-looking statements. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that the results or conditions described in such statements or our objectives and plans will be achieved.

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FLAGSTAR BANCORP, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2012

TABLE OF CONTENTS




PART I. – FINANCIAL INFORMATION		4

Item 1.	Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	63
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	117
Item 4.	Controls and Procedures	118

PART II. – OTHER INFORMATION		119

Item 1.	Legal Proceedings	119
Item 1A.	Risk Factors	119
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	121
Item 3.	Defaults upon Senior Securities	122
Item 4.	Mine Safety Disclosures	122
Item 5.	Other Information	122
Item 6.	Exhibits	123

SIGNATURES		124

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

The consolidated financial statements of the Company are as follows:

Consolidated Statements of Financial Condition – September 30, 2012 (unaudited) and December 31, 2011

Consolidated Statements of Operations – For the three and nine months ended September 30, 2012 and 2011 (unaudited)

Consolidated Statements of Comprehensive Income (Loss) – For the three and nine months ended September 30, 2012 and 2011 (unaudited)

Consolidated Statements of Stockholders’ Equity – For the nine months ended September 30, 2012 and 2011 (unaudited)

Consolidated Statements of Cash Flows – For the nine months ended September 30, 2012 and 2011 (unaudited)

Notes to the Consolidated Financial Statements (unaudited)

Note 1 - Nature of Business

Note 2 - Basis of Presentation and Accounting Policies

Note 3 - Fair Value Accounting

Note 4 - Investment Securities

Note 5 - Loans Held-for-Sale

Note 6 - Loans Repurchased With Government Guarantees

Note 7 - Loans Held-for-Investment

Note 8 - Pledged Assets

Note 9 - Private-Label Securitization Activity

Note 10 - Mortgage Servicing Rights

Note 11 - Derivative Financial Instruments

Note 12 - FHLB Advances

Note 13 - Long-Term Debt

Note 14 - Representation and Warranty Reserve

Note 15 - Warrant Liabilities

Note 16 - Stockholders' Equity

Note 17 - Earnings (Loss) Per Share

Note 18 - Compensation Plans

Note 19 - Income Taxes

Note 20 - Legal Proceedings, Contingencies and Commitments

Note 21 - Segment Information

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Flagstar Bancorp, Inc.

Consolidated Statements of Financial Condition

(In thousands, except share data)



	September 30, 2012			December 31, 2011
	(Unaudited)
Assets
Cash and cash items	$	53,883		$	49,715
Interest-earning deposits	949,514			681,343
Cash and cash equivalents	1,003,397			731,058
Securities classified as trading	170,073			313,383
Securities classified as available-for-sale	198,861			481,352
Loans held-for-sale ($3,076,994 and $1,629,618 at fair value at September 30, 2012 and December 31, 2011, respectively)	3,251,936			1,800,885
Loans repurchased with government guarantees	1,931,163			1,899,267
Loans held-for-investment ($21,392 and $22,651 at fair value at September 30, 2012 and December 31, 2011, respectively)	6,552,399			7,038,587
Less: allowance for loan losses	(305,000		)	(318,000		)
Loans held-for-investment, net	6,247,399			6,720,587
Total interest-earning assets	12,748,946			11,896,817
Accrued interest receivable	106,458			105,200
Repossessed assets, net	119,468			114,715
Federal Home Loan Bank stock	301,737			301,737
Premises and equipment, net	211,981			203,578
Mortgage servicing rights at fair value	686,799			510,475
Other assets	669,950			455,236
Total assets	$	14,899,222		$	13,637,473
Liabilities and Stockholders’ Equity
Deposits	$	9,489,169		$	7,689,988
Federal Home Loan Bank advances	3,088,000			3,953,000
Long-term debt	248,560			248,585
Total interest-bearing liabilities	12,825,729			11,891,573
Accrued interest payable	12,522			8,723
Representation and warranty reserve	202,000			120,000
Other liabilities ($19,100 and $18,300 at fair value at September 30, 2012 and December 31, 2011, respectively)	608,372			537,461
Total liabilities	13,648,623			12,557,757
Commitments and contingencies – Note 20	—			—
Stockholders’ Equity
Preferred stock $0.01 par value, liquidation value $1,000 per share, 25,000,000 shares authorized; 266,657 issued and outstanding at September 30, 2012 and December 31, 2011, respectively	258,973			254,732
Common stock $0.01 par value, 70,000,000 shares authorized; 55,828,470 and 55,577,564 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively	5,583			5,558
Additional paid in capital	1,470,355			1,466,461
Accumulated other comprehensive loss	(2,042		)	(7,819		)
Accumulated deficit	(482,270		)	(639,216		)
Total stockholders’ equity	1,250,599			1,079,716
Total liabilities and stockholders’ equity	$	14,899,222		$	13,637,473

The accompanying notes are an integral part of these Consolidated Financial Statements.

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Flagstar Bancorp, Inc. Consolidated Statements of Operations (In thousands, except per share data)

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
	(Unaudited)
Interest Income
Loans	$	114,158		$	109,966		$	343,677		$	310,234
Securities classified as available-for-sale or trading	4,912			9,626			20,333			26,673
Interest-earning deposits and other	672			433			1,546			2,358
Total interest income	119,742			120,025			365,556			339,265
Interest Expense
Deposits	17,819			22,679			55,126			74,603
FHLB advances	27,091			30,121			81,870			90,317
Other	1,753			1,611			5,270			4,834
Total interest expense	46,663			54,411			142,266			169,754
Net interest income	73,079			65,614			223,290			169,511
Provision for loan losses	52,595			36,690			225,696			113,383
Net interest income (expense) after provision for loan losses	20,484			28,924			(2,406		)	56,128
Non-Interest Income
Loan fees and charges	37,359			18,383			102,116			49,233
Deposit fees and charges	5,255			7,953			15,216			23,297
Loan administration	11,099			(3,478		)	74,997			66,308
Gain (loss) on trading securities	237			20,385			(2,023		)	20,414
Loss on transferors’ interest	(118		)	(186		)	(1,771		)	(4,825		)
Net gain on loan sales	334,427			103,858			751,945			193,869
Net loss on sales of mortgage servicing rights	(1,332		)	(2,587		)	(4,631		)	(5,080		)
Net gain on securities available-for-sale	2,616			—			2,946			—
Net gain on sale of assets	—			1,041			—			1,297
Total other-than-temporary impairment gain	—			51,003			2,810			35,993
Loss recognized in other comprehensive income before taxes	—			(52,325		)	(5,002		)	(52,899		)
Net impairment losses recognized in earnings	—			(1,322		)	(2,192		)	(16,906		)
Representation and warranty reserve – change in estimate	(124,492		)	(38,985		)	(231,058		)	(80,776		)
Other fees and charges, net	8,686			7,489			29,903			20,064
Total non-interest income	273,737			112,551			735,448			266,895

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Flagstar Bancorp, Inc. Consolidated Statements of Operations, Continued (In thousands, except per share data)

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
	(Unaudited)
Non-Interest Expense
Compensation and benefits	67,386			55,238			198,776			164,701
Commissions	19,888			10,188			53,193			25,193
Occupancy and equipment	18,833			17,083			54,490			50,669
Asset resolution	12,487			34,515			70,108			95,906
Federal insurance premiums	12,643			10,665			37,071			30,180
Other taxes	2,036			647			3,363			2,178
Warrant expense (income)	1,516			(4,202		)	3,513			(7,027		)
Loss on extinguishment of debt	15,246			—			15,246			—
General and administrative	83,456			26,557			155,975			67,044
Total non-interest expense	233,491			150,691			591,735			428,844
Income (loss) before federal income taxes	60,730			(9,216		)	141,307			(105,821		)
(Benefit) provision for federal income taxes	(20,380		)	264			(19,880		)	792
Net Income (Loss)	81,110			(9,480		)	161,187			(106,613		)
Preferred stock dividend/accretion (1)	(1,417		)	(4,719		)	(4,241		)	(14,148		)
Net income (loss) applicable to common stock	$	79,693		$	(14,199	)	$	156,946		$	(120,761	)
Income (loss) per share
Basic (2)	$	1.37		$	(0.26	)	$	2.63		$	(2.18	)
Diluted (2)	$	1.36		$	(0.26	)	$	2.61		$	(2.18	)


(1)	The preferred stock dividend/accretion for the three and nine months ended September 30, 2012, respectively, represents only the accretion. On January 27, 2012, the Company elected to defer payment of dividends and interest on the preferred stock.


(2)	Restated for a one-for-ten reverse stock split announced September 27, 2012 and began trading on October 11, 2012.

The accompanying notes are an integral part of these Consolidated Financial Statements.

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Flagstar Bancorp, Inc.

Consolidated Statements of Comprehensive Income (Loss)

(In thousands)



	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2012			2011			2012			2011
Net income (loss)	$	81,110		$	(9,480	)	$	161,187		$	(106,613	)
Other comprehensive income (loss), before tax
Securities available-for-sale
Change in net unrealized loss on sale of securities available-for-sale	12,180			(5,040		)	26,411			(4,815		)
Reclassification of gain on sale of securities available-for-sale	(2,616		)	—			(2,946		)	—
Additions for the amount related to the credit loss for which an OTTI impairment was not previously recognized	—			1,322			2,192			16,906
Total securities available-for-sale	9,564			(3,718		)	25,657			12,091
Other comprehensive income, before tax
Deferred tax benefit related to other comprehensive income resulting from non-agency CMO securities sales	(19,880		)	—			(19,880		)	—
Other comprehensive income, net of tax	(10,316		)	(3,718		)	5,777			12,091

Comprehensive income (loss)	$	70,794		$	(13,198	)	$	166,964		$	(94,522	)

The accompanying notes are an integral part of these Consolidated Financial Statements.

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Flagstar Bancorp, Inc.

Consolidated Statements of Stockholders’ Equity

(In thousands)



	Preferred Stock		Common Stock		Additional Paid in Capital			Accumulated Other Comprehensive Income (Loss)			Retained Earnings (Accumulated Deficit)			Total Stockholders’ Equity
Balance at December 31, 2010	$	249,196	$	5,533	$	1,461,373		$	(16,165	)	$	(440,274	)	$	1,259,663
(Unaudited)
Net loss	—		—		—			—			(106,613		)	(106,613		)
Total other comprehensive income	—		—		—			12,091			—			12,091
Restricted stock issued	—		2		(2		)	—			—			—
Dividends on preferred stock	—		—		—			—			(10,000		)	(10,000		)
Accretion of preferred stock	4,148		—		—			—			(4,148		)	—
Stock-based compensation	—		15		4,183			—			—			4,198
Balance at September 30, 2011	$	253,344	$	5,550	$	1,465,554		$	(4,074	)	$	(561,035	)	$	1,159,339
Balance at December 31, 2011	$	254,732	$	5,558	$	1,466,461		$	(7,819	)	$	(639,216	)	$	1,079,716
(Unaudited)
Net income	—		—		—			—			161,187			161,187
Total other comprehensive income	—		—		—			5,777			—			5,777
Restricted stock issued	—		6		(6		)	—			—			—
Dividends on preferred stock	—		—		—			—			—			—
Accretion of preferred stock (1)	4,241		—		—			—			(4,241		)	—
Stock-based compensation	—		19		3,900			—			—			3,919
Balance at September 30, 2012	$	258,973	$	5,583	$	1,470,355		$	(2,042	)	$	(482,270	)	$	1,250,599


(1)	The preferred stock dividend/accretion during the nine months ended September 30, 2012 represents only the accretion. On January 27, 2012, the Company elected to defer payment of dividends and interest on the preferred stock.

The accompanying notes are an integral part of these Consolidated Financial Statements.

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Flagstar Bancorp, Inc. Consolidated Statements of Cash Flows (In thousands)

	For the Nine Months Ended September 30,
	2012			2011
	(Unaudited)
Operating Activities
Net income (loss)	$	161,187		$	(106,613	)
Reconciliation of net income (loss) to net cash used in operating activities
Provision for loan losses	225,696			113,383
Depreciation and amortization	14,774			10,871
Decrease in fair value of residential first mortgage servicing rights	165,897			60,598
Stock-based compensation expense	3,919			4,198
Net (gain) loss on the sale of assets	(6,632		)	208
Net gain on loan sales	(751,945		)	(193,869		)
Net loss on sales of mortgage servicing rights	4,631			5,080
Net gain on securities classified as available-for-sale	(2,946		)	—
Other than temporary impairment losses on securities classified as available-for-sale	2,192			16,906
Net loss (gain) on trading securities	2,023			(20,414		)
Net loss on transferor interest	1,771			4,825
Proceeds from sales of loans held-for-sale	38,985,990			17,446,482
Origination and repurchase of mortgage loans held-for-sale, net of principal repayments	(39,807,021		)	(16,832,399		)
Increase in repurchase of mortgage loans with government guarantees, net of claims received	(31,895		)	(71,222		)
Purchase of trading securities	—			(131,746		)
Increase in accrued interest receivable	(1,258		)	(16,549		)
Proceeds from sales of trading securities	141,220			—
(Increase) decrease in other assets	(216,266		)	99,370
Increase (decrease) in accrued interest payable	3,799			(4,513		)
(Decrease) increase liability for checks issued	(711		)	4,911
Decrease in payable for mortgage repurchase option	(25,828		)	(3,478		)
Increase in representation and warranty reserve	82,000			5,600
Increase in other liabilities	164,700			70,954
Net cash (used in) provided by operating activities	(884,703		)	462,583
Investing Activities
Proceeds from the sale of investment securities available-for-sale	234,212			—
Net repayment (purchase) of investment securities available-for-sale	54,074			(50,887		)
Net change from sales of loans held-for-investment	(248,640		)	(26,331		)
Origination of portfolio loans, net of principal repayments	156,320			(724,220		)
Proceeds from the disposition of repossessed assets	91,580			89,816
Redemption of Federal Home Loan Bank Stock	—			35,453
Acquisitions of premises and equipment, net of proceeds	(22,387		)	(29,113		)
Proceeds from the sale of mortgage servicing rights	24,712			83,255
Net cash provided by (used in) investing activities	289,871			(622,027		)

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Flagstar Bancorp, Inc. Consolidated Statements of Cash Flows, continued (In thousands)

	For the Nine Months Ended September 30,
	2012			2011
	(Unaudited)
Financing Activities
Net increase in deposit accounts	1,799,181			130,159
Net decrease in Federal Home Loan Bank advances	(865,000		)	(110,083		)
Payment on long-term debt	(25		)	(25		)
Net (disbursement) receipt of payments of loans serviced for others	(94,013		)	82,673
Net receipt of escrow payments	27,028			15,984
Dividends paid to preferred stockholders	—			(10,000		)
Net cash provided by financing activities	867,171			108,708
Net increase (decrease) in cash and cash equivalents	272,339			(50,736		)
Beginning cash and cash equivalents	731,058			953,534
Ending cash and cash equivalents	$	1,003,397		$	902,798
Loans held-for-investment transferred to repossessed assets	$	328,384		$	159,007
Total interest payments made on deposits and other borrowings	$	138,466		$	174,267
Federal income taxes paid	$	225		$	—
Reclassification of mortgage loans originated for portfolio to mortgage loans held-for-sale	$	288,428		$	42,891
Reclassification of mortgage loans originated held-for-sale then transferred to portfolio loans	$	39,788		$	16,560
Mortgage servicing rights resulting from sale or securitization of loans	$	370,013		$	153,465

The accompanying notes are an integral part of these Consolidated Financial Statements.

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Flagstar Bancorp, Inc.

Notes to the Consolidated Financial Statements (Unaudited)

Note 1 – Nature of Business

Flagstar Bancorp, Inc. ("Flagstar" or the "Company"), is the holding company for Flagstar Bank, FSB (the "Bank"), a federally chartered stock savings bank founded in 1987. With $14.9 billion in total assets at September 30, 2012, the Company is the largest insured depository institution headquartered in Michigan and is the largest publicly held savings bank headquartered in the Midwest.

The Company is a full-service financial services company, offering a range of products and services to consumers, businesses, and homeowners. As of September 30, 2012, the Company operated 111 banking centers in Michigan, 31 home loan centers in 14 states, and a total of four commercial banking offices in Massachusetts, Connecticut, and Rhode Island. During the second quarter 2012, two banking centers in Michigan were closed to better align the branch structure with the Company's focus on key market areas and to improve banking center efficiencies. The Company originates loans nationwide and is one of the leading originators of residential first mortgage loans. The Company also offers consumer products including deposit accounts, standard and jumbo home loans, home equity lines of credit, and personal loans, including auto and boat loans. The Company also offers commercial loans and treasury management services throughout Michigan and through the commercial banking offices. Commercial products include deposit and sweep accounts, telephone banking, term loans and lines of credit, lease financing, government banking products and treasury management services such as remote deposit and merchant services.

The Company sells or securitizes most of the mortgage loans that it originates and generally retains the right to service the mortgage loans that it sells. These mortgage-servicing rights ("MSRs") are occasionally sold by the Company in transactions separate from the sale of the underlying mortgages. The Company has, from time to time, retained certain loan originations in the held-for-investment portfolio, although the Company has sold substantially all of its originations for the past several years. The decision-making process to retain certain loan originations has, in the past, taken into account interest rate management, liquidity and capital factors, and generally occur infrequently and within well-defined guidelines and parameters.

The Bank is subject to regulation, examination and supervision by the Office of the Comptroller of the Currency ("OCC") of the United States Department of the Treasury ("U.S. Treasury"). The Bank is also subject to regulation, examination and supervision by the Federal Deposit Insurance Corporation ("FDIC") and the Consumer Financial Protection Bureau (the "CFPB"). The Bank's deposits are insured by the FDIC through the Deposit Insurance Fund ("DIF"). The Company is subject to regulation, examination and supervision by the Board of Governors of the Federal Reserve ("Federal Reserve"). The Bank is also a member of the Federal Home Loan Bank ("FHLB") of Indianapolis.

Reverse Stock Split

The Company's board of directors authorized a one-for-ten reverse stock split on September 24, 2012 following the annual meeting of stockholders at which the reverse stock split was approved by its stockholders. The reverse stock split began trading on a post-split basis on October 11, 2012. Unless noted otherwise, all share-related amounts herein reflect the one-for-ten reverse stock split.

In connection with the reverse stock split, stockholders received one new share of common stock for every ten shares held at the effective time. The reverse stock split reduced the number of shares of outstanding common stock from approximately 558.3 million to 55.8 million. The number of authorized shares of common stock was reduced from 700 million to 70 million. Proportional adjustments were made to the Company’s outstanding options, warrants and other securities entitling their holders to purchase or receive shares of common stock. In lieu of fractional shares, stockholders received cash payments for fractional shares that were determined on the basis of the common stock's closing price on October 9, 2012, adjusted for the reverse stock split. The reverse stock split did not negatively affect any of the rights that accrue to holders of the Company's outstanding options, warrants and other securities entitling their holders to purchase or receive shares of common stock, except to adjust the number of shares relating thereto accordingly. For further information, see Note 16 - Stockholders' Equity and Note 17 - Earnings (Loss) per Common Share.

Management Change

On October 1, 2012, the Company announced that its and the Bank's respective boards of directors appointed Michael J. Tierney to serve as President of the Company and the Bank, effective immediately, and as Chief Executive Officer of each entity, effective November 1, 2012, in each case subject to receipt of regulatory non-objection. Such non-objection has since been received from the Company's and the Bank's regulators. Upon becoming CEO, Mr. Tierney will join the Company's board of directors. The Company also announced that John D. Lewis, Managing Director of Donnelly Penman & Partners and former Vice

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Chairman of Comerica Bank, has been appointed a director of the Company and the Bank and will serve as Non-Executive Chairman of their respective boards of directors, in each case subject to receipt of regulatory non-objection.

Consent Order

Effective October 23, 2012, the Bank's board of directors executed a Stipulation and Consent (the “Stipulation”), accepting the issuance of a Consent Order (the “Consent Order”) by the OCC. The Consent Order replaces the supervisory agreement entered into between the Bank and the Office of Thrift Supervision (the “OTS”) on January 27, 2010. The Company is still subject to a supervisory agreement, dated January 27, 2010, with the Federal Reserve. The OCC terminated the supervisory agreement simultaneous with issuance of the Consent Order.

Under the terms of the Consent Order, the Bank has agreed to, among other things, take the following actions:

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within 120 days of the date of the Consent Order, and at least annually thereafter, the Bank's board of directors shall review, revise, and forward to the OCC a written capital plan for the Bank covering at least a three-year period and establishing projections for the Bank's overall risk profile, earnings performance, growth expectations, balance sheet mix, off-balance sheet activities, liability and funding structure, capital and liquidity adequacy, as well as a contingency capital funding process and plan that identifies alternative capital sources should the primary sources not be available;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall review, revise, adopt and forward to the OCC written policies and procedures for maintaining an adequate allowance for loan and lease losses in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”);


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall review, revise, adopt and forward to the OCC written policies and procedures for maintaining an adequate representation and warranty reserve in accordance with U.S. GAAP;


•	within 60 days of the date of the Consent Order, the Bank's board of directors shall adopt and forward to the OCC a comprehensive written liquidity risk management policy that systematically requires the Bank to reduce liquidity risk;


•	within 60 days of the date of the Consent Order, the Bank's board of directors shall adopt, implement, and ensure Bank adherence to an independent, internal audit program covering all Bank operations and shall implement appropriate actions to remedy deficiencies cited in such audit reports;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall develop, adopt, and forward to the OCC a written enterprise risk management program that is designed to ensure that the Bank effectively identifies, monitors, and controls its enterprise-wide risks, including by developing risk limits for each line of business;

•

within 90 days of the date of the Consent Order, the Bank's board of directors shall adopt, implement, and ensure Bank adherence to an independent, ongoing loan review system to review the Bank's loan and lease portfolios, which system shall provide for the filing with the Bank's board of directors of internal loan and lease review reports and shall require the Bank's board of directors to review the reports and take immediate remedial action if appropriate;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall establish, adopt, and forward to the OCC written policies and procedures designed to identify, measure, monitor, and control risks associated with the Bank's credit concentrations;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall review, revise, and ensure Bank adherence to the Bank's written Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) Risk Assessment to ensure BSA/AML risks posed to the Bank are accurately identified after consideration of all pertinent information;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall review, revise, and ensure Bank adherence to the Bank's written program of policies and procedures adopted in accordance with the Bank Secrecy Act (“BSA”), which shall include the production of periodic reports designed to identify, monitor, and evaluate unusual or suspicious activity;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall update the status of its plan and timeline for the implementation of enhanced BSA/AML internal controls and shall forward a copy of the plan and timeline to the OCC;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall review, revise, and ensure Bank adherence to its risk-based processes to obtain and analyze appropriate information from its customer due diligence program, both at the time of account opening and on an ongoing basis, in order to effectively monitor for, and investigate, suspicious or unusual activity;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall review, revise, and ensure Bank adherence to its BSA independent testing program;


•	within 90 days of the date of the Consent Order, the Bank's board of directors shall adopt and forward to the OCC a written program to improve the Bank's compliance management process, which the Bank's board of directors shall implement and ensure compliance with following the OCC's determination of non-objection;

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•

within 60 days of the date of the Consent Order, the Bank's board of directors shall adopt, implement, and ensure Bank adherence to (i) written Flood Disaster Protection Act (“FDPA”) policies and procedures detailing a coordinated program to ensure Bank compliance with the FDPA, and (ii) a comprehensive FDPA training program for all applicable lending staff to ensure awareness of their FDPA compliance responsibilities; and


•	within 180 days of the date of the Consent Order, the Bank's board of directors shall adopt and forward to the OCC a comprehensive written business continuity plan, which the Bank's board of directors shall implement and ensure compliance with following the OCC's determination of non-objection.

Each of the plans, policies and procedures referenced above that the Consent Order requires the Bank to submit to the OCC, as well as any subsequent amendments or changes thereto, must be submitted for a determination that the OCC has no supervisory objection to them. Upon receiving a determination of no supervisory objection from the OCC, the Bank must implement and adhere to the respective plan, policy or procedure.

The Consent Order also requires the Bank to establish a Compliance Committee to oversee the Bank's adherence to the provision of the Consent Order. The Bank's board of directors has re-designated the Bank's existing Regulatory Oversight Committee as its Compliance Committee. The current members of the Compliance Committee are Jay J. Hansen, David J. Matlin, Peter Schoels and David L. Treadwell. The Compliance Committee is responsible for monitoring and coordinating the Bank's adherence to the provisions of the Consent Order. The Bank's board of directors has appointed John D. Lewis to serve as the Chairman of the Compliance Committee, replacing Mr. Treadwell, effective upon receipt of OCC non-objection to Mr. Lewis's appointment to the Bank's board of directors. In addition, the Board has appointed Peter Schoels to serve as Vice Chairman of the Committee, effective upon receipt of non-objection to Mr. Schoels's election to the Board of Directors of the Company from the Federal Reserve, an application for which is pending. Mr. Schoels became a director of the Bank effective October 5, 2012 upon the Bank's receipt of OCC's non-objection to Mr. Schoels's appointment to the Bank's board of directors.

The Bank intends to address the banking issues identified by the OCC in the manner and within the time periods required for compliance with the Consent Order, and the Company does not believe that the Bank's continued compliance with the Consent Order will have any material adverse impact on the Company or the Bank's future financial results.

The foregoing summary of the Stipulation and the Consent Order does not purport to be a complete description of all of the terms of such documents, and is qualified in its entirety by reference to copies of the Stipulation and the Consent Order filed with the SEC on October 24, 2012 as exhibits to the Company's Current Report on Form 8-K.

Supervisory Agreement

The Company is subject to a supervisory agreement, dated January 27, 2010, with the Federal Reserve, as a successor regulator to the OTS (the "Supervisory Agreement"). The Supervisory Agreement will remain in effect until terminated, modified, or suspended in writing by the Federal Reserve, and the failure to comply with the Supervisory Agreement could result in the initiation of further enforcement action by the Federal Reserve, including the imposition of further operating restrictions, and could result in additional enforcement actions against the Company. The Company has taken actions which it believes are appropriate to comply with, and intend to maintain compliance with, all of the requirements of the Supervisory Agreement.

Pursuant to the Supervisory Agreement, the Company submitted a capital plan to the OTS, predecessor in interest to the Federal Reserve. In addition, the Company agreed to request prior non-objection of the Federal Reserve to pay dividends or other capital distributions; purchases, repurchases or redemptions of certain securities; incurrence, issuance, renewal, rolling over or increase of any debt and certain affiliate transactions; and comply with restrictions on the payment of severance and indemnification payments, director and management changes and employment contracts and compensation arrangements. The foregoing summary of the Supervisory Agreement does not purport to be a complete description of all of the terms of the Supervisory Agreement, and is qualified in its entirety by reference to the copy of the Supervisory Agreement filed with the SEC as an exhibit to the Company's Current Report on Form 8-K filed on January 28, 2010.

The Company addressed the banking issues identified by the Federal Reserve in the manner and within the time periods required for compliance with the Supervisory Agreement, and does not believe that continued compliance with the Supervisory Agreement will have any material adverse impact on its future financial results.

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Branch Sales

During the fourth quarter 2011, the Bank completed the previously announced sale of 27 banking centers in Georgia and 22 banking centers in Indiana to PNC Bank, N.A., part of The PNC Financial Services Group, Inc. ("PNC") and First Financial Bank, N.A. ("First Financial"), respectively. Management believed that the Company's presence in the Georgia and Indiana markets lacked market density and sufficient scale, and that these transactions are consistent with the strategic focus on core Midwest banking markets and on deployment of capital towards continuing growth in commercial and consumer banking, while remaining a national mortgage lender.

In the Georgia sale, PNC purchased the facilities or assumed the leases associated with the banking centers and purchased associated business and retail deposits in the amount of $211.3 million. PNC paid the net carrying value of the acquired real estate and fixed and other personal assets associated with the banking centers.

In the Indiana sale, First Financial paid a consideration of a seven percent premium on the consumer and commercial deposits in the Indiana banking centers. The total amount of such consumer and commercial deposits was $462.0 million for a gain of $22.1 million. First Financial paid net carrying value on real estate and personal assets of the banking centers and assumed the existing leases on 14 of the banking centers.

The Company predominantly originated residential mortgage loans for sale in the secondary market in both the Georgia and Indiana markets. Accordingly, the amount of loans on the balance sheet was immaterial and no loans were transferred in either transaction.

Troubled Asset Relief Program

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (initially introduced as the Troubled Asset Relief Program ("TARP")) was enacted, and the U.S. Treasury injected capital into U.S. financial institutions. On January 30, 2009, the Company entered into a letter agreement including the securities purchase agreement with the U.S. Treasury pursuant to which, among other things, the Company sold to the U.S. Treasury preferred stock and warrants. Furthermore, as long as the preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Company's common stock, par value $0.01 per share (the "Common Stock"), are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. The preferred stock accrues cumulative dividends quarterly at a rate of 5 percent per annum until January 30, 2014, and 9 percent per annum thereafter.

On January 27, 2012, the Company exercised its contractual right to defer regularly scheduled quarterly payments of dividends, beginning with the February 2012 payment, on preferred stock issued and outstanding in connection with participation in the TARP Capital Purchase Program. Under the terms of the preferred stock, the Company may defer payments of dividends for up to six quarters in total without default or penalty. Concurrently, the Company also exercised contractual rights to defer interest payments with respect to its trust preferred securities.

Note 2 – Basis of Presentation and Accounting Policies

The unaudited consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the SEC. Accordingly, they do not include all the information and footnotes required by U.S. GAAP for complete financial statements. The accompanying interim financial statements are unaudited; however, in the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three and nine months ended September 30, 2012, are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. In addition, certain prior period amounts have been reclassified to conform to the current period presentation. All per share amounts and share counts have been adjusted to reflect the one-for-ten reverse stock split that began trading on a post-split basis October 11, 2012 following receipt of stockholder approval at the Company's annual meeting of stockholders. For further information, reference should be made to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, which are available on the Company’s Investor Relations web page, at www.flagstar.com, and on the SEC website, at www.sec.gov.

Recently Adopted Accounting Standards

On July 1, 2012, the Company adopted an update to Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 360, "Property, Plant, and Equipment: Derecognition of in Substance Real Estate - a Scope Clarification" and applied the provisions prospectively. The guidance represents the consensus reached in Emerging Issues Task

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Force Issue No. 10-E, "Derecognition of in Substance Real Estate" and applies to a parent that ceases to have a controlling financial interest in a subsidiary that is in substance real estate as a result of default on the subsidiary's nonrecourse debt. The guidance provides that when a parent (reporting entity) ceases to have a controlling financial interest in a subsidiary that is in substance real estate as a result of default on the subsidiary's nonrecourse debt. The adoption of the guidance did not have a material effect on the Company's Consolidated Financial Statements or the Notes thereto.

On January 1, 2012, the Company adopted the update to FASB ASC Topic 220, "Comprehensive Income" and applied the provisions retrospectively. Under the amended guidance, an entity had the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income ("OCI") either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The adoption of the guidance did not have a material effect on the Company's Consolidated Financial Statements or the Notes thereto. For further information concerning comprehensive income, refer to Consolidated Statements of Comprehensive Income and Note 15 - Stockholders' Equity.

On January 1, 2012, the Company prospectively adopted the update to FASB ASC Topic 820, "Fair Value Measurement." The amended guidance did not modify the requirements for when fair value measurements apply, rather it generally represents clarifications on how to measure and disclose fair value under Topic 820, Fair Value Measurement. The guidance is intended to improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and International Financial Reporting Standards ("IFRS"), by ensuring that fair value has the same meaning in U.S. GAAP and IFRS and respective disclosure requirements are the same except for inconsequential differences in wording and style. The adoption of the guidance did not have a material effect on the Company's Consolidated Financial Statements or the Notes thereto. For further information concerning fair value, refer to Note 3 - Fair Value Accounting.

On January 1, 2012, the Company adopted FASB ASC Topic 860, "Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreements." Under the amended guidance, a transferor maintains effective control over transferred financial assets if there is an agreement that both entitles and obligates the transferor to repurchase the financial assets before maturity. In addition, the following requirements must be met: (i) the financial asset to be repurchased or redeemed are the same or substantially the same as those transferred, (ii) the agreement is to repurchase or redeem the transferred financial asset before maturity at a fixed or determinable price, and (iii) the agreement is entered into contemporaneously with, or in contemplation of the transfer. The adoption of the guidance did not have a material effect on the Company's Consolidated Financial Statements or the Notes thereto.

On July 1, 2011, the Company adopted the update to FASB ASC Topic 310, "Receivables - A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring" and applied the provisions retrospectively to January 1, 2011. The troubled debt restructuring ("TDR") guidance clarifies whether loan modifications constitute TDRs, includes factors and examples for creditors to consider in evaluating whether a restructuring results in a delay in payment that is insignificant, prohibits creditors from using the borrower's effective rate test to evaluate whether the restructuring constitutes as a TDR and a concession has been granted to the borrower, and clarifies the guidance for creditors to use in determining whether a borrower is experiencing financial difficulties. The adoption of the guidance did not have a material effect on the Company's Consolidated Financial Statements or the Notes thereto. For further information concerning TDRs, refer to Note 7 - Loans Held-for-Investment.

Recent Accounting Pronouncements

In December 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-11, "Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities." The guidance requires an entity to disclose information about offsetting and related arrangements to enable users of financial statements to understand the effect of those arrangements on its financial position. The FASB issued common disclosure requirements related to offsetting arrangements to allow investors to better compare financial statements prepared in accordance with IFRS or U.S. GAAP. The objective of this guidance is to facilitate comparison between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS. This guidance is effective retrospectively, for annual and interim periods, beginning on or after January 1, 2013. The adoption of the guidance is not expected to have a material impact on the Company's Consolidated Financial Statements or the Notes thereto.

Regulatory Developments

The following updates previous disclosures on recent market and industry developments, including with respect to regulatory developments, mortgage matters and governmental programs. Among the recent legislative and regulatory developments

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affecting the banking industry are evolving regulatory capital standards for banking organizations. These evolving standards include the so-called "Basel III" initiatives that are part of the effort by international banking supervisors to improve the ability of the banking sector to absorb shocks in periods of financial and economic stress and changes by the federal banking agencies to reduce the use of credit ratings in the rules governing regulatory capital.

In June 2012, the U.S. banking regulators requested comment on three sets of proposed rules that implement the Basel III capital framework and also make other changes to U.S. regulatory capital standards for banking institutions. The Basel III proposed rules include heightened capital requirements for banking institutions in terms of both higher quality capital and higher regulatory capital ratios. These proposed rules, among other things, would revise the capital levels at which a banking institution would be subject to the prompt corrective action framework (including the establishment of a new tier 1 common capital requirement), eliminate or reduce the ability of certain types of capital instruments to count as regulatory capital, eliminate the Tier 1 treatment of trust preferred securities (as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act) following a phase-in period beginning in 2013, and require new deductions from capital for investments in unconsolidated financial institutions, mortgage servicing assets and deferred tax assets that exceed specified thresholds. The proposed rules also would establish a new capital conservation buffer and, for large or internationally active banks, a supplemental leverage capital requirement that would take into account certain off-balance sheet exposures and a countercyclical capital buffer that would initially be set at zero. The proposed Basel III rules would become effective under a phase-in period beginning January 1, 2013 and to be in full effect on January 1, 2019.

In addition, proposed rules issued by the U.S. banking regulators in June 2012 would also revise the manner in which a banking institution determines risk-weighted assets for risk-based capital purposes under the Basel II framework applicable to large or internationally active banks (referred to as the advanced approach) and under the Basel I framework applicable to all banking institutions (referred to as the standardized approach). These rules would replace references to credit ratings with alternative methodologies for assessing creditworthiness. In addition, among other things, the advanced approach proposal would implement the changes to counterparty credit risk weightings included in the Basel III capital framework, and the standardized approach would modify the risk weighting framework for residential mortgage assets. The standardized approach changes to the Basel I risk-weighting rules are proposed to become effective no later than July 1, 2015.

In June 2012, the U.S. banking regulators also adopted final market risk capital rules to implement the enhancements to the market risk framework adopted by the Basel Committee (commonly referred to as "Basel II.5"). The final rules are effective January 1, 2013 and, among other things, establish new stressed Value at Risk ("VaR") and incremental risk charges for covered trading positions and replace references to credit ratings in the market risk rules with alternative methodologies for assessing credit risk.

In June 2012, the Federal Reserve and other U.S. regulators issued a Notice of Proposed Rulemaking (“NPR”), related to capital adequacy rules, to address implementation of the Basel III framework for financial institutions in the United States. While much of the NPR was consistent with the Basel III framework that was updated in June of 2011, there are some substantial differences from that original framework. The Company is continuing to do an analysis of the NPR; however, as currently proposed, risk-weighted assets will increase primarily due to the ranges of risk-weightings for residential first mortgage and home equity loans, resulting in a decline in capital ratios. The regulatory agencies asked financial institutions to provide comment on the NPR and are expected to consider the feedback and draft a final rule. Accordingly, the final rule may differ from the current NPR. Further, the NPR indicates a phase-in for the new capital rules with the proposed risk-weightings requirement not becoming effective until 2015.

Note 3 – Fair Value Accounting

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability, in either case through an orderly transaction between market participants at the measurement date. The Company utilizes fair value measurements to record certain assets and liabilities at fair value and to determine fair value disclosures. The determination of fair values of financial instruments often requires the use of estimates. In cases where quoted market values in an active market are not available, the Company uses present value techniques and other valuation methods to estimate the fair values of its financial instruments. These valuation models rely on market-based parameters when available, such as interest rate yield curves, credit spreads or unobservable inputs. Unobservable inputs may be based on management's judgment, assumptions and estimates related to credit quality, asset growth, the Company's future earnings, interest rates and other relevant inputs. These valuation methods require considerable judgment and the resulting estimates of fair value can be significantly affected by the assumptions made and methods used.

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Valuation Hierarchy

U.S. GAAP establishes a three-level valuation hierarchy for disclosure of fair value measurements that is based on the transparency of the inputs used in the valuation process. The three levels of the hierarchy, highest ranking to lowest, are as follow:

Level 1 -Quoted prices (unadjusted) for identical assets or liabilities in active markets in which the Company can participate as of the measurement date;

Level 2 -Quoted prices for similar instruments in active markets, and other inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; and

Level 3 -Unobservable inputs that reflect the Company's own assumptions about the expectations that market participants would use in pricing and asset or liability.

A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input within the valuation hierarchy that is significant to the overall fair value measurement. Transfers between levels of the fair value hierarchy are recognized at the end of the reporting period.

The following is a description of the valuation methodologies used by the Company for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Assets

Securities classified as trading. These securities are comprised of U.S. government sponsored agency securities, U.S. Treasury bonds and non-investment grade residual securities that arose from private-label securitizations of the Company. The U.S. government sponsored agency securities and U.S. Treasury bonds trade in an active, open market with readily observable prices and are therefore classified within the Level 1 valuation hierarchy. The non-investment grade residual securities do not trade in an active, open market with readily observable prices and are therefore classified within the Level 3 valuation hierarchy. Under Level 3, the fair value of residual securities is determined by discounting estimated net future cash flows using expected prepayment rates and discount rates that approximate current market rates. Estimated net future cash flows include assumptions related to expected credit losses on these securities. The Company maintains a model that evaluates the default rate and severity of loss on the residual securities collateral, considering such factors as loss experience, delinquencies, loan-to-value ratios, borrower credit scores and property type. At September 30, 2012 and December 31, 2011, the Company had no Level 3 securities classified as trading. See Note 9 - Private-Label Securitization Activity, for the key assumptions used in the residual interest valuation process.

Securities classified as available-for-sale. These securities are comprised of U.S. government sponsored agencies and non-agency collateralized mortgage obligations ("CMOs") and municipal obligations.


•	U.S. government sponsored agencies are classified within Level 1 of the valuation hierarchy due to the quoted prices for these securities being available in an active market.


•	The quoted market prices are not available for municipal obligations and the fair values are estimated using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows and those securities are classified within Level 2 of the valuation hierarchy.

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Non-agency CMOs are classified within Level 2 of the valuation hierarchy and were previously classified within Level 3. Non-agency CMOs were transferred from Level 3 to Level 2 during the first quarter 2012 due to increased market liquidity and an increase in the number of available pricing models. The non-agency CMOs are valued based on pricing provided by external pricing services. Previously, the markets were illiquid and fair values were based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement, which was the reason for a Level 3 classification. As of September 30, 2012, the Company sold the remaining securities in non-agency collateralized mortgage obligation securities that were related to the investments arising out of strategies to fully utilize available balance sheet leverage capacity.


•	Due to illiquidity in the markets, the Company determined the fair value of the mortgage securitization, Flagstar Home Equity Loan Trust 2006-1 (“FSTAR 2006-1”) securitization trust, using a discounted estimated net future cash flow model and therefore classified it within the Level 3 valuation hierarchy as the model utilizes significant inputs which are unobservable.

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Loans held-for-sale. The Company generally estimates the fair value of mortgage loans held-for-sale based on quoted market prices for securities backed by similar types of loans. Where quoted market prices were available, such market prices were utilized as estimates for fair values. Otherwise, the fair value of loans was computed by discounting cash flows using observable inputs inclusive of interest rates, prepayment speeds and loss assumptions for similar collateral. These measurements are classified as Level 2.

Loans held-for-investment. Loans held-for-investment are generally recorded at amortized cost. The Company does not record these loans at fair value on a recurring basis. However, from time to time a loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Once a loan is identified as impaired, the fair value of the impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, or discounted cash flows. The fair value of the underlying collateral is determined, where possible, using market prices derived from appraisals or broker price opinions which are considered to be Level 3. Fair value may also be measured using the present value of expected cash flows discounted at the loan's effective interest rate. The Company records the impaired loan as a non-recurring Level 3 valuation.

Loans held-for-investment on a recurring basis are loans that were previously recorded as loans held-for-sale but subsequently transferred to the held-for-investment category. As the Company selected the fair value option for the held-for-sale loans, they continue to be reported at fair value and measured consistent with the Level 2 methodology for loans held-for-sale.

Included in loans held-for-investment is the transferor's interest on the home equity line of credit ("HELOC") securitizations. The Company fair value of the transferor's interest is based on the claims due to the note insurer and continuing credit losses on the loans underlying the securitizations, which are considered to be Level 3. See Note 9 - Private-Label Securitization Activity, for the key assumptions used in the transferor's interest valuation process.

Repossessed assets. Loans on which the underlying collateral has been repossessed are adjusted to fair value less costs to sell upon transfer to repossessed assets. Subsequently, repossessed assets are carried at the lower of carrying value or fair value, less anticipated marketing and selling costs. Fair value is generally based upon third-party appraisals or internal estimates and considered a Level 3 classification.

Residential MSRs. The current market for residential MSRs is not sufficiently liquid to provide participants with quoted market prices. Therefore, the Company uses an option-adjusted spread valuation approach to determine the fair value of residential MSRs. This approach consists of projecting servicing cash flows under multiple interest rate scenarios and discounting these cash flows using risk-adjusted discount rates. The key assumptions used in the valuation of residential MSRs include mortgage prepayment speeds and discount rates. Management obtains third-party valuations of the residential MSR portfolio on a quarterly basis from independent valuation experts to assess the reasonableness of the fair value calculated by its internal valuation model. Due to the nature of the valuation inputs, residential MSRs are classified within Level 3 of the valuation hierarchy. See Note 10 - Mortgage Servicing Rights, for the key assumptions used in the residential MSR valuation process.

Derivative financial instruments. Certain classes of derivative contracts are listed on an exchange and are actively traded, and they are therefore classified within Level 1 of the valuation hierarchy. These include U.S. Treasury futures and U.S. Treasury options. The Company's forward loan sale commitments and interest rate swaps are valued based on quoted prices for similar assets in an active market with inputs that are observable and are classified within Level 2 of the valuation hierarchy. Rate lock commitments are valued using internal models with significant unobservable market parameters and therefore are classified within Level 3 of the valuation hierarchy. The Company assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and determined that the credit valuation adjustments were not significant to the overall valuation of its derivatives. The derivatives are reported in either "other assets" or "other liabilities" on the Consolidated Statements of Financial Condition.

Equity-linked transaction and option commitment. The Company previously offered, for a short period of time, the equity-linked transaction and option commitments as a hedge (off-set) to the market risk incurred with the Company's participation of equity-linked certificates of deposit. The option represents the premium over the total notional amount of the hedge. The valuations are based on counter-party risk systems measuring the present value of each instrument and its future payments. The risk systems take into consideration economic terms of the trade and current market levels including spot rates, and underlying volatility and correlation among other factors.

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Liabilities

Warrants. Warrant liabilities are valued using a binomial lattice model and are classified within Level 2 of the valuation hierarchy. Significant observable inputs include expected volatility, a risk free rate and an expected life. Warrant liabilities are reported in "other liabilities" on the Consolidated Statements of Financial Condition.

Litigation settlement. On February 24, 2012, the Company announced that the Bank had entered into an agreement (the "DOJ Agreement") with the U.S. Department of Justice ("DOJ") relating to certain underwriting practices associated with loans insured by the Federal Housing Administration ("FHA") of the Department of Housing and Urban Development ("HUD"). The Bank and the DOJ entered into the DOJ Agreement pursuant to which the Bank agreed to comply with all applicable HUD and FHA rules related to the continued participation in the direct endorsement lender program, make an initial payment of $15.0 million within 30 business days of the effective date of the DOJ Agreement (paid on April 3, 2012), make payments of approximately $118.0 million contingent upon the occurrence of certain future events (as further described below) (the "Additional Payments"), and complete a monitoring period by an independent third party chosen by the Bank and approved by HUD.

Based on analysis of the DOJ Agreement, the Company recorded a liability of $33.3 million at December 31, 2011. During the nine months ended September 30, 2012, the Company recorded an increase to the liability of $0.8 million, principally representing the recognition of the periodic effect of discounting. During the second quarter 2012, a payment of $15.0 million was paid against the liability. At September 30, 2012 the liability was $19.1 million, which represents the estimated fair value of the $118.0 million Additional Payments. Future changes in the fair value of the Additional Payments could affect in future earnings each quarters.

The Company has elected the fair value option to account for the liability representing the obligation to make Additional Payments under the DOJ Agreement. The signed settlement contract with the DOJ establishes a legally enforceable contract with a stipulated payment plan that meets the definition of a financial liability. The Company made the fair value election as of December 31, 2011, the date the Company first recognized the financial instrument in its financial statements.

The specific terms of the payment structure are as follow:


•	The Company generates positive income for a sustained period, such that part or all of the Deferred Tax Asset ("DTA"), which has been offset by a valuation allowance ("DTA Valuation Allowance"), is likely to be realized, as evidenced by the reversal of the DTA Valuation Allowance in accordance with U.S. GAAP;


•	The Company is able to include capital derived from the reversal of the DTA Valuation Allowance in the Bank's Tier 1 capital, which is the lesser of 10 percent of Tier 1 capital or the amount of the DTA that the Company expects to recover within one year based on financial projections;


•	The Company's obligation to repay the $266.7 million in preferred stock held by the U.S. Treasury under the TARP Capital Purchase Program has been either extinguished or excluded from Tier 1 capital for purposes of calculating the Tier 1 capital ratio as described in the paragraph below;

•

Upon the occurrence of each of the future events described above, and provided doing so would not violate any banking regulatory requirement or the OCC does not otherwise object, the Company will begin making Additional Payments provided that (i) each annual payment would be equal to the lesser of $25 million or the portion of the Additional Payments that remains outstanding after deducting prior payments; and (ii) no obligation arises until the Company's call report as filed with the OCC, including any amendments thereto, for the period ending at least six months prior to the making of such Additional Payments, reflects a minimum Tier 1 capital ratio of 11 percent (or higher if required by regulators), after excluding any unextinguished portion of the preferred stock held by U.S. Treasury under the TARP Capital Purchase Program; and


•	In no event will the Company be required to make an Additional Payment if doing so would violate any material banking regulatory requirement or the OCC (or any successor regulator under the safety and soundness program) objects in writing to the making of an Additional Payment.

The fair value of the DOJ Agreement is based on a discounted cash flow valuation model that incorporates the Company's current estimate of the most likely timing and amount of the cash flows necessary to satisfy the obligation. These cash flow estimates are reflective of the Company's detailed financial and operating projections for the next three years, as well as more general growth earnings and capital assumptions for subsequent periods.

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The timing of each of the metrics is dependent on the preceding metric being achieved and actual Bank operating results and forecasted assumptions could materially change the value of the liability. As the Bank's profitability increases, the value of the deferred liability would also increase.

At September 30, 2012, the cash flows are discounted using a 15.6 percent discount rate that is inclusive of the risk free rate based on the expected duration of the liability and an adjustment for non-performance risk that represents the Company's credit risk. The model assumes 12 quarters of profitability prior to reversing the valuation allowance associated with the deferred tax asset.

The liability is classified within Level 3 of the valuation hierarchy given the projections of earnings and growth rate assumptions are unobservable inputs. The litigation settlement is included in other liabilities on the Consolidated Financial Statements and changes in the fair value of the litigation settlement will be recorded each quarter in general and administrative expense within non-interest expense on the Consolidated Statements of Operations.

Assets and liabilities measured at fair value on a recurring basis

The following tables present the financial instruments carried at fair value as of September 30, 2012 and December 31, 2011, by caption on the Consolidated Statement of Financial Condition and by the valuation hierarchy (as described above).



	Level 1			Level 2			Level 3			Total Fair Value
September 30, 2012	(Dollars in thousands)
Securities classified as trading
U.S. Treasury bonds	$	170,073		$	—		$	—		$	170,073
Securities classified as available-for-sale
Mortgage securitization	—			—			96,108			96,108
U.S. government sponsored agencies	87,397			—			—			87,397
Municipal obligations	—			15,356			—			15,356
Loans held-for-sale
Residential first mortgage loans	—			2,878,503			—			2,878,503
Loans held-for-investment
Residential first mortgage loans	—			20,770			—			20,770
Transferor's interest	—			—			7,617			7,617
Residential mortgage servicing rights	—			—			686,799			686,799
Equity-linked CD purchase option	492			—			—			492
Derivative assets
U.S. Treasury futures	7,750			—			—			7,750
Agency forwards	2,462			—			—			2,462
Rate lock commitments	—			—			230,050			230,050
Interest rate swaps	—			6,079			—			6,079
Total derivative assets	10,212			6,079			230,050			246,341
Total assets at fair value	$	268,174		$	2,920,708		$	1,020,574		$	4,209,456
Derivative liabilities
Forward agency and loan sales	$	—		$	(138,109	)	$	—		$	(138,109	)
Interest rate swaps	—			(6,079		)	—			(6,079		)
Total derivative liabilities	—			(144,188		)	—			(144,188		)
Warrant liabilities	—			(5,925		)	—			(5,925		)
Equity-linked CD written option	(492		)	—			—			(492		)
Litigation settlement	—			—			(19,100		)	(19,100		)
Total liabilities at fair value	$	(492	)	$	(150,113	)	$	(19,100	)	$	(169,705	)

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	Level 1		Level 2			Level 3			Total Fair Value
December 31, 2011	(Dollars in thousands)
Securities classified as trading
U.S. Treasury bonds	$	313,383	$	—		$	—		$	313,383
Securities classified as available-for-sale
Non-agency collateralized mortgage obligations	—		—			254,928			254,928
Mortgage securitization	—		—			110,328			110,328
U.S. government sponsored agencies	116,096		—			—			116,096
Loans held-for-sale
Residential first mortgage loans	—		1,629,618			—			1,629,618
Loans held-for-investment
Residential first mortgage loans	—		22,651			—			22,651
Residential mortgage servicing rights	—		—			510,475			510,475
Derivative assets
U.S. Treasury futures	3,316		—			—			3,316
Rate lock commitments	—		—			70,965			70,965
Agency forwards	9,362		—			—			9,362
Interest rate swaps	—		3,296			—			3,296
Total derivative assets	12,678		3,296			70,965			86,939
Total assets at fair value	$	442,157	$	1,655,565		$	946,696		$	3,044,418
Derivative liabilities
Forward agency and loan sales	$	—	$	(42,978	)	$	—		$	(42,978	)
Interest rate swaps	—		(3,296		)	—			(3,296		)
Total derivative liabilities	—		(46,274		)	—			(46,274		)
Warrant liabilities	—		(2,411		)	—			(2,411		)
Litigation settlement (1)	—		—			(18,300		)	(18,300		)
Total liabilities at fair value	$	—	$	(48,685	)	$	(18,300	)	$	(66,985	)


(1)	Does not include the $15.0 million payment required to be paid within 30 business days after the effective date of the DOJ Agreement, which was paid on April 3, 2012.

A determination to classify a financial instrument within Level 3 of the valuation hierarchy is based upon the significance of the unobservable factors to the overall fair value measurement. However, Level 3 financial instruments typically include, in addition to the unobservable or Level 3 components, observable components (that is, components that are actively quoted and can be validated to external sources). Also, the Company manages the risk associated with the observable components of Level 3 financial instruments using securities and derivative positions that are classified within Level 1 or Level 2 of the valuation hierarchy; these Level 1 and Level 2 risk management instruments are not included below, and therefore the gains and losses in the tables do not reflect the effect of the Company's risk management activities related to such Level 3 instruments. If the market for an instrument becomes more liquid or active and pricing models become available which allow for readily observable inputs, the Company will transfer the instruments from Level 3 to Level 2 valuation hierarchy.

Interest rate swap derivatives were transferred from Level 1 to Level 2 during the fourth quarter 2011 because the derivatives are not actively being traded on a listed exchange. The interest rate swap derivatives are valued based on quoted prices for similar assets in an active market with inputs that are observable and are now classified within Level 2 of the valuation hierarchy.

Non-agency CMOs were transferred from Level 3 to Level 2 during the first quarter 2012 due to increased market liquidity and an increase in the number of available pricing models. The non-agency CMOs are valued based on pricing provided by external pricing services.

Transferor's interest were transferred into Level 3 during the first quarter 2012 due to the assumptions utilized in the valuation of the claims to the note insurer and continuing credit losses on the loans underlying the securitization. Transferor's

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interest are valued based on pricing of the loans underlying the securitization and are now classified within Level 3 of the valuation hierarchy.

The Company had no transfers of recurring assets or liabilities recorded at fair value for three and nine months ended September 30, 2011. The Company reclassified the 2011 nonrecurring hierarchy disclosures for impaired loans and repossessed assets from Level 2 to Level 3 to reflect that the appraised values, broker price opinions or internal estimates contain unobservable inputs. The impact of the transfer did not have a material effect on the Company's Consolidated Financial Statements or the Notes thereto and was limited to disclosure.

Fair value measurements using significant unobservable inputs

The tables below include a roll forward of the Consolidated Statement of Financial Condition amounts for the three and nine months ended September 30, 2012 and 2011 (including the change in fair value) for financial instruments classified by the Company within Level 3 of the valuation hierarchy.



				Recorded in Earnings						Recorded in OCI
For the Three Months Ended September 30, 2012	Balance at Beginning of Period			Total Unrealized Gains / (Losses)			Total Realized Gains / (Losses)			Total Unrealized Gains / (Losses)		Purchases		Sales			Settlements			Transfers In (Out)		Balance at End of Period			Changes In Unrealized Held at End of Period (4)
Assets	(Dollars in thousands)
Securities classified as available-for-sale (1)(2)
Mortgage securitization	$	100,306		$	—		$	—		$	400	$	—	$	(4,598	)	$	—		$	—	$	96,108		$	400
Loans held-for-investment
Transferor's interest	7,660			75			(118		)	—		—		—			—			—		7,617			—
Residential mortgage servicing rights	638,865			(28,762		)	—			—		131,837		(9,589		)	(45,552		)	—		686,799			—
Derivative financial instruments
Rate lock commitments	132,388			255,947			—			—		287,537		(344,909		)	(100,913		)	—		230,050			—
Totals	$	879,219		$	227,260		$	(118	)	$	400	$	419,374	$	(359,096	)	$	(146,465	)	$	—	$	1,020,574		$	400
Liabilities
Litigation settlement	$	(19,100	)	$	—		$	—		$	—	$	—	$	—		$	—		$	—	$	(19,100	)	$	—

For the Three Months Ended September 30, 2011
Securities classified as available-for-sale (1)(2)(3)
Non-agency CMOs	$	294,178		$	—		$	(6,296	)	$	—	$	—	$	(11,003	)	$	—		$	—	$	276,879		$	(4,974	)
Mortgage securitization	124,587			—			—			—		—		(8,217		)	—			—		116,370			—
Residential mortgage servicing rights	577,401			(164,423		)	—			—		64,490		(40,130		)	—			—		437,338			—
Derivative financial instruments
Rate lock commitments	10,920			122,393			—			—		114,066		(101,012		)	(56,305		)	—		90,062			—
Totals	$	1,007,086		$	(42,030	)	$	(6,296	)	$	—	$	178,556	$	(160,362	)	$	(56,305	)	$	—	$	920,649		$	(4,974	)

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				Recorded in Earnings						Recorded in OCI
For the Nine Months Ended September 30, 2012	Balance at Beginning of Period			Total Unrealized Gains / (Losses)			Total Realized Gains / (Losses)			Total Unrealized Gains / (Losses)		Purchases		Sales			Settlements			Transfers In (Out)			Balance at End of Period			Changes In Unrealized Held at End of Period (4)
Assets	(Dollars in thousands)
Securities classified as available-for-sale (1)(2)(3)
Non-agency CMOs	$	254,928		$	—		$	—		$	—	$	—	$	—		$	—		$	(254,928	)	$	—		$	—
Mortgage securitization	110,328			2,091			—			—		—		(16,311		)	—			—			96,108			2,091
Loans held-for-investment
Transferor's interest	—			(206		)	(1,771		)	—		—		—			—			9,594			7,617			—
Residential mortgage servicing rights	510,475			(64,348		)	—			—		370,012		(27,791		)	(101,549		)	—			686,799			—
Derivative financial instruments
Rate lock commitments	70,965			490,712			—			—		673,989		(753,822		)	(251,794		)	—			230,050			—
Totals	$	946,696		$	428,249		$	(1,771	)	$	—	$	1,044,001	$	(797,924	)	$	(353,343	)	$	(245,334	)	$	1,020,574		$	2,091
Liabilities
Litigation settlement	$	(18,300	)	$	—		$	(800	)	$	—	$	—	$	—		$	—		$	—		$	(19,100	)	$	—
For the Nine Months Ended September 30, 2011
Securities classified as available-for-sale (1)(2)(3)
Non-agency CMOs	$	330,781		$	—		$	(3,937	)	$	—	$	—	$	(49,965	)	$	—		$	—		$	276,879		$	12,969
Mortgage securitization	136,707			—			—			—		—		(20,337		)	—			—			116,370			—
Residential mortgage servicing rights	580,299			(209,140		)	—			—		153,444		(87,265		)	—			—			437,338			—
Derivative financial instruments
Rate lock commitments	14,396			160,983			—			—		211,126		(163,453		)	(132,990		)	—			90,062			—
Totals	$	1,062,183		$	(48,157	)	$	(3,937	)	$	—	$	364,570	$	(321,020	)	$	(132,990	)	$	—		$	920,649		$	12,969


(1)	Realized gains (losses), including unrealized losses deemed other-than-temporary and related to credit issues, are reported in non-interest income.

(2)

U.S. government agency securities classified as available-for-sale are valued predominantly using quoted broker/dealer prices with adjustments to reflect for any assumptions a willing market participant would include in its valuation. Non-agency CMOs classified as available-for-sale are valued using internal valuation models and pricing information from third parties. Mortgage securitization is classified as available-for-sale is valued using a discounted estimated net future cash flow model.


(3)	Management had anticipated that the non-agency CMOs would be classified under Level 2 of the valuation hierarchy. However, due to illiquidity in the markets, the fair value of these securities has been determined using internal models and therefore is classified within Level 3 of the valuation hierarchy and pricing information from third parties.


(4)	Changes in the unrealized gains (losses) related to financial instruments held at the end of the period.

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The following tables present the quantitative information about recurring Level 3 fair value financial instruments and the fair value measurements as of September 30, 2012.



	Fair Value			Valuation Technique	Unobservable Input	Range (Weighted Average)
September 30, 2012	(Dollars in thousands)
Assets
Mortgage securitization	$	96,108		Discounted cash flows	Discount rate Prepay rate - 12 month historical average CDR rate - 12 month historical average Loss severity	7.2% - 10.8% (9.0%) 7.6% - 11.4% (9.5%) 4.7% - 7.1% (5.9%) 80.0% - 120.0% (100.0%)
Transferor's interest	$	7,617		Discounted cash flows	Discount rate Prepay rate - 3 month historical average Cumulative loss rate Loss severity	4.6% - 6.9% (5.7%) 9.6% - 14.4% (12.0%) 11.3% - 17.0% (14.1%) 80.0% - 120.0% (100.0%)
Residential mortgage servicing rights	$	686,799		Discounted cash flows	Option adjusted spread Constant prepayment rate Weighted average cost to service per loan	5.1% - 7.7% (6.4%) 16.2% - 24.3% (20.3%) 59.7% - 89.6% (74.7%)
Rate lock commitments	$	230,050		Mark-to-Market	Origination pull-through rate	60.2% - 90.2% (75.2%)
Liabilities
Litigation settlement	$	(19,100	)	Discounted cash flows	Asset growth rate MSR growth rate Return on assets (ROA) improvement Peer group ROA	4.4% - 6.6% (5.5%) 0.9% - 1.4% (1.2%) 0.02% - 0.04% (0.03%) 0.5% - 0.8% (0.7%)

The significant unobservable inputs used in the fair value measurement of the mortgage securitization (FSTAR 2006-1 securitization trust) are discount rates, prepayment rates and default rates. While loss severity (in the event of default) is an unobserveable input, the sensitivity of the fair value to this input is zero because of the insurer coverage on the deal. Significant increases (decreases) in the discount rate in isolation would result in a significantly lower (higher) fair value measurement. Increases in both prepay rates and default rates in isolation result in a higher fair value; however, generally a change in the assumption used for the probability of default is accompanied by a directionally opposite change in the assumption used for prepayment rates, which would offset a portion of the fair value change.

The significant unobservable inputs used in the fair value measurement of the transferor's interest are discount rates, prepayment rates, loss rates and loss severity. Significant increases (decreases) in the discount rate in isolation would result in a significantly lower (higher) fair value measurement. Increases in both prepay rates and loss rates in isolation result in a lower fair value; however, generally a change in the assumption used for the loss rate is accompanied by a directionally opposite change in the assumption used for prepayment rates, which would offset a portion of the fair value change. Significant increases (decreases) in the loss severity rate in isolation would result in a significantly lower (higher) fair value measurement.

The significant unobservable inputs used in the fair value measurement of the MSRs are option adjusted spreads, prepayment rates, and cost to service. Significant increases (decreases) in all three assumptions in isolation would result in a significantly lower (higher) fair value measurement.

The significant unobservable input used in the fair value measurement of the rate lock commitments is the pull through rate. The pull through rate is a statistical analysis of the Company's actual rate lock fallout history to determine the sensitivity of the residential mortgage loan pipeline compared to interest rate changes and other deterministic values. New market prices are applied based on updated loan characteristics and new fall out ratios (i.e., the inverse of the pull through rate) are applied accordingly. Significant increases (decreases) in the pull through rate in isolation would result in a significantly higher (lower) fair value measurement. Generally, a change in the assumption utilized for the probability of default is accompanied by a directionally similar change in the assumption utilized for the loss severity and a directionally opposite change in assumption utilized for prepayment rates.

The significant unobservable inputs used in the fair value measurement of the litigation settlement with DOJ are future balance sheet and growth rate assumptions for overall asset growth, MSR growth, peer group return on assets, and return on assets improvement. The current assumptions are based on management's approved, strategic performance targets beyond the current strategic modeling horizon (2015). The Company's target asset growth rate post 2015 is based off of growth in the balance sheet post TARP preferred stock repayment. Significant increases (decreases) in the Company's growth rate in isolation would result in a significantly lower (higher) fair value measurement. Significant increases (decreases) in the Company's MSR growth rate in isolation would result in a marginally lower (higher) fair value measurement. Significant increases (decreases) in the peer group's return on assets improvement in isolation would result in a marginally higher (lower) fair value measurement. Significant increases

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(decreases) in the Company's return on assets improvement in isolation would result in a marginally higher (lower) fair value measurement. Changes in the regulatory environment could impact the calculation of capital ratio.

The Company also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets are measured at the lower of cost or market and had a fair value below cost at the end of the period as summarized below.

Assets Measured at Fair Value on a Non-recurring Basis



	Total		Level 3
	(Dollars in thousands)
September 30, 2012
Impaired loans held-for-investment (1)
Residential first mortgage loans	$	139,764	$	139,764
Commercial real estate loans	101,289		101,289
Repossessed assets (2)	119,468		119,468
Totals	$	360,521	$	360,521
December 31, 2011
Impaired loans held-for-investment (1)
Residential first mortgage loans	$	210,040	$	210,040
Commercial real estate loans	180,306		180,306
Repossessed assets (2)	114,715		114,715
Totals (3)	$	505,061	$	505,061

(1)

The Company recorded $26.7 million and $116.6 million in fair value losses on impaired loans (included in provision for loan losses on the Consolidated Statements of Operations) during the three and nine months ended September 30, 2012, respectively, compared to $12.0 million and $41.8 million in fair value losses on impaired loans during the three and nine months ended September 30, 2011, respectively.

(2)

The Company recorded a gain of $(0.9) million and a loss of $8.9 million related to write-downs of repossessed assets based on the estimated fair value of the specific assets, and recognized net gains of $4.2 million and $7.3 million on sales of repossessed assets during the three and nine months ended September 30, 2012, respectively, compared to $5.5 million and $17.7 million in losses related to write-downs of repossessed assets based on the estimated fair value of the specific assets, and recognized net gains of $2.0 million and $2.7 million on sales of repossessed assets during the three and nine months ended September 30, 2011, respectively.


(3)	As of December 31, 2011, the Company reclassified impaired loans and repossessed assets from Level 2 to Level 3 to reflect that many of the appraised values, price opinions or internal estimates contain unobservable inputs.

The following tables present the quantitative information about non-recurring Level 3 fair value financial instruments and the fair value measurements as of September 30, 2012.



	Fair Value		Valuation Technique(s)	Unobservable Input	Range (Weighted Average)
September 30, 2012	(Dollars in thousands)
Impaired loans held-for-investment
Residential mortgage loans	$	139,764	Fair value of collateral	Loss severity discount	0% - 100% (47.3%)
Commercial real estate loans	$	101,289	Fair value of collateral	Loss severity discount	0% - 100% (48.4%)
Repossessed assets	$	119,468	Fair value of collateral	Loss severity discount	0% - 86.8% (48.1%)

The Company has certain impaired residential and commercial real estate loans that are measured at fair value on a nonrecurring basis. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. Appraisals or other third party price opinions are generally obtained to support the fair value of the collateral and incorporate measures such as recent sales prices for comparable properties. In cases where the carrying value exceeds the fair value of the collateral less cost to sell, an impairment charge is recognized.

Repossessed assets are measured and reported at fair value through a charge-off to the allowance for loan losses based upon the fair value of the repossessed asset. The fair value of repossessed assets, upon initial recognition, are estimated using Level 3 inputs based on customized discounting criteria. The significant unobservable inputs used in the Level 3 fair value

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measurements of the Company's impaired loans and repossessed assets included in the table above primarily relate to internal valuations or analysis.

Fair Value of Financial Instruments

The accounting guidance for financial instruments requires disclosures of the estimated fair value of certain financial instruments and the methods and significant assumptions used to estimate their fair values. Certain financial instruments and all non-financial instruments are excluded from the scope of this guidance. Accordingly, the fair value disclosures required by this guidance are only indicative of the value of individual financial instruments as of the dates indicated and should not be considered an indication of the fair value of the Company.

The following table presents the carrying amount and estimated fair value of certain financial instruments not recorded at fair value in entirety on a recurring basis.



	September 30, 2012
				Estimated Fair Value
	Carrying Value			Total			Level 1		Level 2			Level 3
	(Dollars in thousands)
Financial Instruments
Assets
Cash and cash equivalents	$	1,003,397		$	1,003,397		$	1,003,397	$	—		$	—
Securities classified as trading	170,073			170,073			170,073		—			—
Securities classified as available-for-sale	198,861			198,861			87,397		15,356			96,108
Loans held-for-sale	3,251,936			3,113,188			—		3,113,188			—
Loans repurchased with government guarantees	1,931,163			1,833,917			—		1,833,917			—
Loans held-for-investment, net	6,247,399			6,266,760			—		20,770			6,245,990
Accrued interest receivable	106,458			106,458			—		106,458			—
Repossessed assets	119,468			119,468			—		—			119,468
FHLB stock	301,737			301,737			301,737		—			—
Mortgage servicing rights	686,799			686,799			—		—			686,799
Customer initiated derivative interest rate swaps	6,079			6,079			—		6,079			—
Equity-linked CD purchase option	492			492			492		—			—
Liabilities
Retail deposits
Demand deposits and savings accounts	(2,795,476		)	(2,733,946		)	—		(2,733,946		)	—
Certificates of deposit	(3,271,501		)	(3,298,392		)	—