FBC 2014.03.31 10-Q
Table of Contents

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 March 31, 2014
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

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)

Not applicable
(Former name, former address and formal fiscal year, if changed since last report)
 
  
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 90 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 May 8, 2014, 56,222,107 shares of the registrant’s common stock, $0.01 par value, were issued and outstanding.

Table of Contents

FLAGSTAR BANCORP, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2014
TABLE OF CONTENTS
 
 
 
 
 
Item 1.
 
Consolidated Statements of Financial Condition – March 31, 2014 (unaudited) and December 31, 2013
 
Consolidated Statements of Operations – For the three months ended March 31, 2014 and 2013 (unaudited)
 
Consolidated Statements of Comprehensive Income (Loss) – For the three months ended March 31, 2014 and 2013 (unaudited)
 
Consolidated Statements of Stockholders’ Equity  – For the three months ended March 31, 2014 and 2013 (unaudited)
 
Consolidated Statements of Cash Flows – For the three months ended March 31, 2014 and 2013 (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.


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Table of Contents

FLAGSTAR BANCORP, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2014
TABLE OF CONTENTS (continued)

 
 
Item 1.
   Item 1A.  
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 


3
Table of Contents

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Flagstar Bancorp, Inc.
Consolidated Statements of Financial Condition
(In thousands, except share data)
 
March 31, 2014
 
December 31, 2013
 
(Unaudited)
 
 
Assets
 
 
 
Cash and cash equivalents
 
 
 
Cash and cash items ($1,761 and $1,129 of consolidated VIEs, respectively) (1)
$
56,968

 
$
55,913

Interest-earning deposits
162,229

 
224,592

Total cash and cash equivalents
219,197

 
280,505

Investment securities available-for-sale
1,207,430

 
1,045,548

Loans held-for-sale ($1,372,978 and $1,140,507 measured at fair value, respectively) (2)
1,673,763

 
1,480,418

Loans repurchased with government guarantees
1,266,702

 
1,273,690

Loans held-for-investment, net


 
 
Loans held-for-investment ($233,854 and $238,322 measured at fair value which includes $150,595 and $155,012 of consolidated VIEs, respectively) (1) (2)
4,019,871

 
4,055,756

Less: allowance for loan losses
(307,000
)
 
(207,000
)
Total loans held-for-investment, net
3,712,871

 
3,848,756

Mortgage servicing rights
320,231

 
284,678

Repossessed assets, net
31,076

 
36,636

Federal Home Loan Bank stock
209,737

 
209,737

Premises and equipment, net
233,195

 
231,350

Net deferred tax asset
451,392

 
414,681

Other assets
285,759

 
301,302

Total assets
$
9,611,353

 
$
9,407,301

Liabilities and Stockholders’ Equity
 
 
 
Deposits
 
 
 
Noninterest bearing
$
983,348

 
$
930,060

Interest bearing
5,326,953

 
5,210,266

Total deposits
6,310,301

 
6,140,326

Federal Home Loan Bank advances
1,125,000

 
988,000

Long-term debt ($101,710 and $105,813 of consolidated VIEs at fair value, respectively) (1) (2)
349,145

 
353,248

Representation and warranty reserve
48,000

 
54,000

Other liabilities ($94,000 and $93,000 measured at fair value and $136 and $136 of consolidated VIEs, respectively) (1) (2)
427,627

 
445,853

Total liabilities
8,260,073

 
7,981,427

Stockholders’ Equity
 
 
 
Preferred stock $0.01 par value, liquidation value $1,000 per share, 25,000,000 shares authorized; 266,657 issued and outstanding, respectively
266,657

 
266,174

Common stock $0.01 par value, 70,000,000 shares authorized; 56,221,056 and 56,138,074 shares issued and outstanding, respectively
562

 
561

Additional paid in capital
1,479,459

 
1,479,265

Accumulated other comprehensive loss
(1,197
)
 
(4,831
)
Accumulated deficit
(394,201
)
 
(315,295
)
Total stockholders’ equity
1,351,280

 
1,425,874

Total liabilities and stockholders’ equity
$
9,611,353

 
$
9,407,301

(1)
Amounts represent the assets and liabilities of consolidated variable interest entities ("VIEs").
(2)
Amounts represent the assets and liabilities for which the Company has elected the fair value option.

    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)
 
Three Months Ended March 31,
 
2014
 
2013
 
(Unaudited)
Interest Income
 
 
 
Loans
$
58,668

 
$
91,950

Investment securities available-for-sale or trading
7,538

 
2,094

Interest-earning deposits and other
145

 
946

Total interest income
66,351

 
94,990

Interest Expense
 
 
 
Deposits
5,988

 
13,508

Federal Home Loan Bank advances
534

 
24,161

Other
1,628

 
1,652

Total interest expense
8,150

 
39,321

Net interest income
58,201

 
55,669

Provision for loan losses
112,321

 
20,415

Net interest (loss) income after provision for loan losses
(54,120
)
 
35,254

Noninterest Income
 
 
 
Loan fees and charges
12,311

 
33,360

Deposit fees and charges
4,764

 
5,146

Loan administration
19,584

 
20,356

Net gain on loan sales
45,342

 
137,540

Net transaction costs on sales of mortgage servicing rights
3,583

 
(4,219
)
Net gain on sale of assets
2,216

 
958

Representation and warranty reserve – change in estimate
1,672

 
(17,395
)
Other noninterest (loss) income
(14,519
)
 
9,197

Total noninterest income
74,953

 
184,943

Noninterest Expense
 
 
 
Compensation and benefits
65,572

 
77,208

Commissions
7,220

 
17,462

Occupancy and equipment
20,410

 
19,375

Asset resolution
11,508

 
16,445

Federal insurance premiums
5,010

 
11,240

Loan processing expense
7,735

 
17,111

Legal and professional expense
13,902

 
28,839

Other noninterest expense
7,895

 
8,910

Total noninterest expense
139,252

 
196,590


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Flagstar Bancorp, Inc.
Consolidated Statements of Operations, Continued
(In thousands, except per share data)
 
Three Months Ended March 31,
 
2014
 
2013
 
(Unaudited)
(Loss) income before income taxes
(118,419
)
 
23,607

Benefit for income taxes
(39,996
)
 
—

Net (Loss) Income
(78,423
)
 
23,607

Preferred stock dividend/accretion
(483
)
 
(1,438
)
Net (loss) income applicable to common stock
$
(78,906
)
 
$
22,169

(Loss) income per share
 
 
 
Basic
$
(1.51
)
 
$
0.33

Diluted
$
(1.51
)
 
$
0.33

Weighted average shares outstanding
 
 
 
Basic
56,194,184

 
55,973,888

Diluted
56,194,184

 
56,415,057


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

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Flagstar Bancorp, Inc.
Consolidated Statements of Comprehensive (Loss) Income
(In thousands)

 
Three Months Ended March 31,
 
2014
 
2013
 
(Unaudited)
Net (loss) income
$
(78,423
)
 
$
23,607

Other comprehensive income, before tax
 
 
 
Investment securities available-for-sale
 
 
 
Unrealized gains on investment securities available-for-sale
5,869

 
1,002

Reclassification of gain on sale of investment securities available-for-sale
(223
)
 
—

Total investment securities available-for-sale, before tax
5,646

 
1,002

Other comprehensive income, deferred tax benefit
 
 
 
Deferred tax benefit related to other comprehensive income resulting from unrealized gains and losses on investment securities available-for-sale
(2,200
)
 
—

Deferred tax benefit related to other comprehensive income resulting from the dissolution and sales of investments securities available-for-sale
188

 
—

Other comprehensive income, net of tax
3,634

 
1,002

Comprehensive (loss) income
$
(74,789
)
 
$
24,609

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, 2012
$
260,390

 
$
559

 
$
1,476,569

 
$
(1,658
)
 
$
(576,498
)
 
$
1,159,362

(Unaudited)
 
 
 
 
 
 
 
 
 
 
 
Net income
—

 
—

 
—

 
—

 
23,607

 
23,607

Total other comprehensive income
—

 
—

 
—

 
1,002

 
—

 
1,002

Restricted stock issued
—

 
1

 
(1
)
 
—

 
—

 
—

Accretion of preferred stock
1,438

 
—

 
—

 
—

 
(1,438
)
 
—

Stock-based compensation
—

 
1

 
56

 
—

 
—

 
57

Balance at March 31, 2013
$
261,828

 
$
561

 
$
1,476,624

 
$
(656
)
 
$
(554,329
)
 
$
1,184,028

Balance at December 31, 2013
$
266,174

 
$
561

 
$
1,479,265

 
$
(4,831
)
 
$
(315,295
)
 
$
1,425,874

(Unaudited)
 
 
 
 
 
 
 
 
 
 
 
Net loss
—

 
—

 
—

 
—

 
(78,423
)
 
(78,423
)
Total other comprehensive income
—

 
—

 
—

 
3,634

 
—

 
3,634

Restricted stock issued
—

 
1

 
(1
)
 
—

 
—

 
—

Accretion of preferred stock
483

 
—

 
—

 
—

 
(483
)
 
—

Stock-based compensation
—

 
—

 
195

 
—

 
—

 
195

Balance at March 31, 2014
$
266,657

 
$
562

 
$
1,479,459

 
$
(1,197
)
 
$
(394,201
)
 
$
1,351,280



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

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Table of Contents

Flagstar Bancorp, Inc.
Consolidated Statements of Cash Flows
(In thousands)
 
Three Months Ended March 31,
 
2014
 
2013
 
(Unaudited)
Operating Activities
 
 
 
Net (loss) income
$
(78,423
)
 
$
23,607

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
Provision for loan losses
112,321

 
20,415

Depreciation and amortization
5,760

 
5,404

Loss on fair value of mortgage servicing rights
9,592

 
15,641

Loss of fair value of long-term debt
1,324

 
—

Net gain on the sale of assets
(2,974
)
 
(7,034
)
Net gain on loan sales
(45,342
)
 
(137,540
)
Net transaction costs on sales of mortgage servicing rights
(3,583
)
 
4,219

Net gain on investment securities
(223
)
 
—

Net gain on trading securities
—

 
(51
)
Proceeds from sales of loans held-for-sale
3,555,682

 
13,850,730

Origination and repurchase of loans held-for-sale, net of principal repayments
(5,296,103
)
 
(12,623,530
)
Net change in:
 
 
 
Decrease in repurchase loans with government guarantees, net of claims received
6,989

 
236,436

(Increase) decrease in accrued interest receivable
(3,183
)
 
10,936

(Increase) decrease in other assets
(16,077
)
 
76,280

Increase in payable for mortgage repurchase option
(4,973
)
 
(13,966
)
Representation and warranty reserve - change in estimate
(1,672
)
 
17,395

Net charge-offs in representation and warranty reserve
(5,557
)
 
(31,213
)
Decrease in other liabilities
(41,189
)
 
(32,653
)
Net cash (used in) provided by operating activities
(1,807,631
)
 
1,415,076

Investing Activities
 
 
 
Proceeds received from the sale of investment securities available-for-sale
1,846,339

 
—

Repayment of investment securities available-for-sale
30,729

 
15,378

Purchase of investment securities available-for-sale
(205,497
)
 
—

Net change from sales of loans held-for-investment
(276,412
)
 
61,645

Principal repayments net of origination of loans held-for-investment
13,773

 
635,929

Proceeds from the disposition of repossessed assets
10,004

 
27,285

Acquisitions of premises and equipment, net of proceeds
(7,786
)
 
(9,379
)
Proceeds from the sale of mortgage servicing rights
5,690

 
89,928

Net cash provided by investing activities
1,416,840

 
820,786

 
 
 
 

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Flagstar Bancorp, Inc.
Consolidated Statements of Cash Flows, continued
(In thousands)
 
Three Months Ended March 31,
 
2014
 
2013
 
(Unaudited)
Financing Activities
 
 
 
Net increase (decrease) in deposit accounts
169,975

 
(447,004
)
Net increase (decrease) in Federal Home Loan Bank advances
137,000

 
(280,000
)
Payment on long-term debt
(5,427
)
 
—

Net disbursement of payments of loans serviced for others
24,895

 
(234,846
)
Net receipt of escrow payments
3,040

 
3,881

Net cash provided by (used in) financing activities
329,483

 
(957,969
)
Net (decrease) increase in cash and cash equivalents
(61,308
)
 
1,277,893

Beginning cash and cash equivalents
280,505

 
952,793

Ending cash and cash equivalents
$
219,197

 
$
2,230,686

Supplemental disclosure of cash flow information
 
 
 
Loans held-for-investment transferred to repossessed assets
$
15,971

 
$
50,247

Interest paid on deposits and other borrowings
$
6,233

 
$
37,339

Income taxes paid
$
333

 
$
6,671

Reclassification of loans originated for investment to loans held-for-sale
$
281,040

 
$
1,129

Reclassification of mortgage loans originated held-for-sale then to loans held-for-investment
$
4,628

 
$
62,774

Mortgage servicing rights resulting from sale or securitization of loans
$
51,043

 
$
126,494


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"), the holding company for Flagstar Bank, FSB (the "Bank") is a Michigan-based savings and loan holding company founded in 1993. The Company's business is primarily conducted through its principal subsidiary, the Bank, a federally chartered stock savings bank founded in 1987. At March 31, 2014, the Company's total assets were $9.6 billion. The Company has the largest bank headquartered in Michigan and one of the top ten largest savings banks in the United States.

In preparing these consolidated financial statements, subsequent events were evaluated through the time the financial statements were issued. The consolidated financial statements are considered issued when they are widely distributed to all stockholders and other financial statement users, or filed with the U.S. Securities and Exchange Commission ("SEC"). All material subsequent events have been either recognized in the Consolidated Financial Statements or disclosed in the Notes to the Consolidated Financial Statements.

In January 2014, the Company reorganized the manner in which its operations are managed based on core operating functions. The segments are based on an internally-aligned segment leadership structure, which is also how the results are monitored and performance assessed. The Company's business model emphasizes the delivery of a complete set of mortgage and banking products and services, including originating, acquiring, selling and servicing one-to-four family residential first mortgage loans, which we believe is distinguished by timely processing and customer service.

The Company's operations are conducted through four operating segments: Mortgage Originations, Mortgage Servicing, Community Banking and Other, which includes the remaining reported activities. The Mortgage Originations segment, in which the Company originates or purchases residential first mortgage loans throughout the country and sells them into securitization pools, primarily to Federal National Mortgage Association ("Fannie Mae"), Federal Home Loan Mortgage Corporation ("Freddie Mac") and Government National Mortgage Association ("Ginnie Mae") (collectively, the "Agencies") or as whole loans. The Mortgage Servicing segment services mortgage loans on a fee basis for others and residential mortgages held-for-investment by the Community Banking segment and mortgage servicing rights held by the Other segment. The Company has retained certain loan originations in the held-for-investment portfolio, which are held by the Community Banking segment. Mortgage loans are originated through 33 home loan centers located in 18 states, a direct to consumer call center, the Internet, wholesale brokers and correspondents.

The Company also offers a range of products and services to consumers and businesses through the Community Banking segment. As of March 31, 2014, the Company operated 106 banking centers in Michigan. The Company offers consumer products including deposit accounts, commercial loans and personal loans, including auto and boat loans. The Company offers treasury management services. Commercial products offered include deposit and sweep accounts, telephone banking, term loans and lines of credit, lease financing, government banking products and treasury management services including remote deposit and merchant services.
    
The Bank is subject to regulation, examination and supervision by the Office of the Comptroller of the Currency ("OCC") of the U.S. 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. 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.

Note 2 – Basis of Presentation, Accounting Policies and Recent Developments

The accompanying unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the SEC for interim financial information. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America ("U.S. GAAP") for complete financial statements. These interim financial statements include all adjustments, consisting of normal recurring accruals that management believes are necessary for a fair presentation of the results of operations, financial position and cash flows. The results of operations for the three months ended March 31, 2014, are not necessarily indicative of the results that may be expected for any other interim period or for the full year ending December 31, 2014. In addition, certain prior period amounts have been reclassified to conform to the current period presentation. These consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form

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10-K for the year ended December 31, 2013, which are available on the Company’s Investor Relations web page, at www.flagstar.com, and on the SEC website, at www.sec.gov.

Variable Interest Entities

The accompanying unaudited consolidated financial statements include variable interest entities ("VIEs") in which the Company has determined to have a controlling financial interest. The Company consolidates a VIE if it has: (i) a variable interest in the entity; (ii) the power to direct activities of the VIE that most significantly impact the entity's economic performance; and (iii) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE (i.e., the Company is considered to be the primary beneficiary).

A VIE is an entity that lacks equity investors or whose equity investors do not have a controlling financial interest in the entity through their equity investments. The entity that has a controlling financial interest in a VIE is referred to as the primary beneficiary and consolidates the VIE. On a quarterly basis, the Company will reassesses whether it has a controlling financial interest in and is the primary beneficiary of a VIE. The quarterly reassessment process considers whether the Company has acquired or divested the power to direct the activities of the VIE through changes in governing documents or other circumstances.

The reassessment also considers whether the Company has acquired or disposed of a financial interest that could be significant to the VIE, or whether an interest in the VIE has become significant or is no longer significant. The consolidation status of the VIEs with which the Company is involved may change as a result of such reassessments. Changes in consolidation status are applied prospectively, with assets and liabilities of a newly consolidated VIE initially recorded at fair value. A gain or loss may be recognized upon deconsolidation of a VIE depending on the carrying amounts of deconsolidated assets and liabilities compared to the fair value of retained interests and ongoing contractual arrangements. The Company primarily uses VIEs for its securitization activities, in which the Company transfers whole loans or debt securities into a trust or other vehicle such that the assets are legally isolated from the creditors of the Company. Assets held in a trust can only be used to settle obligations of the trust. The creditors of these trusts typically have no recourse to the Company except in accordance with the Company's obligations under standard representations and warranties. When the Company is the servicer of whole loans held in a securitization trust, including home equity loans, the Company has the power to direct the most significant activities of the trust. The Company does not have the power to direct the most significant activities of a residential mortgage agency trust unless the Company holds substantially all of the issued securities and has the unilateral right to liquidate the trust. The Company consolidates a whole-loan securitization trust if it has the power to direct the most significant activities and also holds securities issued by the trust or has other contractual arrangements, other than standard representations and warranties, which could potentially be significant to the trust.

At June 30, 2013, the Company became the primary beneficiary of the FSTAR 2005-1 and FSTAR 2006-2 HELOC securitization trusts because the Company obtained the power to direct the activities that most significantly impact the economic performance of the trusts (power to select or remove the servicer) and the obligation to absorb expected losses and receive residual returns (support of the guarantor and holder of residual interests in trusts), which is reflected in the Consolidated Financial Statements as a VIE. See Note 8 for information on VIEs.

Recently Issued Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board ("FASB") or other standard setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the impact of recently issued standards that are not yet effective will not have a material impact on the Consolidated Financial Statements or the Notes thereto or results of operations upon adoption.

In January 2014, the FASB issued ASU No. 2014-04, "Receivables-Troubled Debt Restructurings by Creditors (Topic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure." The guidance amends the guidance in the FASB Accounting Standards Codification Topic 310-40, "Receivables - Troubled Debt Restructurings by Creditors," in efforts to reduce diversity in practice through clarifying when an in substance repossession or foreclosure occurs. Essentially, the guidance addresses when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan so that the loan should be derecognized and the real estate property recognized in the financial statements. This guidance is effective prospectively, for annual and interim periods, beginning after December 15, 2014. The adoption of the guidance is not expected to have a material impact on the consolidated financial statements or the Notes thereto.


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Recent Developments

Organizational Restructuring

On January 16, 2014, the Company completed an organizational restructuring to reduce expenses consistent with its previously communicated strategy of optimizing its cost structure across all business lines. As part of this restructuring initiative, the Company has reduced full-time equivalents by approximately 350 during the first quarter 2014. Including the restructuring completed in the third quarter 2013, the Company has reduced staffing levels across the organization by approximately 600 full-time equivalents from its September 30, 2013 level.

Sale of Mortgage Servicing Rights

On December 18, 2013, the Company entered into a definitive agreement to sell $40.7 billion unpaid principal balance (net of write downs) of its MSR portfolio to Matrix Financial Services Corporation ("Matrix"), a wholly owned subsidiary of Two Harbors Investment Corp. Covered under the agreement are certain mortgage loans serviced for both Fannie Mae and Ginnie Mae, originated primarily after 2010. Simultaneously, the Company entered into an agreement with Matrix to subservice the residential mortgage loans sold to Matrix. As a result, the Company will receive subservicing income and retain a portion of the ancillary fees to be paid as the subservicer of the loans.

Note 3 – Fair Value Measurements

The Company utilizes fair value measurements to record certain assets and liabilities at fair value and to determine fair value disclosures. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability through an orderly transaction between market participants at the measurement date. 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, 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.

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 follows.

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 an 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.
    

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

Assets

Investment securities available-for-sale. These securities are comprised of U.S. government sponsored agencies and municipal obligations. The Company measures fair value using prices obtained from pricing services. A review is performed on the security prices received from the pricing services, which includes discussion and analysis of the inputs used by the pricing services to value our securities. Where possible, fair values are generated using market inputs including quoted prices (the closing price in an exchange markets), bid prices (the price at which a buyer stands ready to purchase) and other market information. For fixed income securities that are not actively traded, the pricing services use alternative methods to determine fair value for the securities, including; quotes for similar fixed-income securities, matrix pricing, discounted cash flow using benchmark curves or other factors to determine fair value. U.S. government sponsored agencies are classified within Level 1 of the valuation hierarchy and all other debt securities are classified as Level 2 of the valuation hierarchy.

Loans held-for-sale. The Company generally estimates the fair value of 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 becomes 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 loans 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.

The HELOC loans associated with the FSTAR 2005-1 and FSTAR 2006-2 securitization trusts have been recorded in the Consolidated Financial Statement as loans held-for-investment. These loans are recorded at fair value using the present value of expected cash flows discounted at market rates typical of assets with similar risk profiles. The Company records these loans as a recurring Level 3 valuation.

Also, included in loans held-for-investment are the second mortgage loans associated with the previous FSTAR 2006-1 mortgage securitization trust. The loans are carried at fair value and valued using a discounted estimated net future cash flow model and therefore classified within the Level 3 valuation hierarchy as the model utilizes significant inputs which are unobservable. See Note 8 - Private-Label Securitization and Variable Interest Entities for additional information.

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 fair value estimates based on repossessed asset experience and considered a Level 3 classification.

MSRs. The current market for 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 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 MSRs include mortgage prepayment speeds and discount rates. Management obtains third-party valuations of the MSR portfolio on a quarterly basis from independent valuation experts to assess the reasonableness of the fair value calculated by its internal valuation model. In certain circumstances, based on the probability of the completion of a sale of MSRs pursuant to a bona-fide purchase offer, the Company considers the bid price of that offer and identifiable transaction costs in comparison to the calculated fair value and may adjust the estimate of fair value to reflect the terms of the pending transaction. Due to the nature of the valuation inputs, MSRs are classified within Level 3 of

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the valuation hierarchy. See Note 9 - 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.

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.

Long-term debt. The Company records the long-term debt associated with the FSTAR 2005-1 and FSTAR 2006-2 HELOC securitization trusts at fair value. The fair value of the debt is estimated using quantitative models which incorporate observable and, in some instances, unobservable inputs including security prices, interest rate yield curves, option volatility, currency, commodity or equity rates and correlations between these inputs. The Company also considers the impact of its own credit spreads in determining the discount rate used to value these liabilities. The credit spread is determined by reference to observable spreads in the secondary bond markets, which are considered to be Level 3. The Company records this debt as a recurring Level 3 valuation.

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, make payments of approximately $118.0 million contingent upon the occurrence of certain future events (the "Additional Payments"), and complete a monitoring period by an independent third party chosen by the Bank and approved by HUD. The Company made the initial payment of $15.0 million on April 3, 2012.

The Company elected the fair value option to account for the liability representing the obligation to make Additional Payments under the DOJ Agreement. As of March 31, 2014, the Bank has accrued $94.0 million, which represents the fair value of the Additional Payments. The signed DOJ Agreement establishes a legally enforceable contract with a stipulated payment plan that meets the definition of a financial liability.

At March 31, 2014 and December 31, 2013, the cash flows were discounted using a 9.5 percent and 9.9 percent, respectively, 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 that the Company will have met substantially all of the stipulations required for the commencement of payments to the DOJ.

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 other noninterest expense on the Consolidated Statements of Operations. See Note 19 - Legal Proceedings, Contingencies and Commitments, for further information on the DOJ litigation settlement.


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Assets and liabilities measured at fair value on a recurring basis

The following tables present the financial instruments carried at fair value as of March 31, 2014 and December 31, 2013, by caption on the Consolidated Statement of Financial Condition and by level in the valuation hierarchy (as described above).
 
Level 1
 
Level 2
 
Level 3
 
Total  Fair
Value
March 31, 2014
(Dollars in thousands)
Investment securities available-for-sale
 
 
 
 
 
 
 
U.S. government sponsored agencies
$
1,195,066

 
$
—

 
$
—

 
$
1,195,066

       Municipal obligations
—

 
12,364

 
—

 
12,364

Loans held-for-sale
 
 
 
 
 
 
 
Residential first mortgage loans
—

 
1,372,978

 
—

 
1,372,978

Loans held-for-investment
 
 
 
 
 
 
 
Residential first mortgage loans
—

 
21,719

 
—

 
21,719

Second mortgage loans
—

 
—

 
61,540

 
61,540

HELOC loans
—

 
—

 
150,595

 
150,595

Mortgage servicing rights
—

 
—

 
320,231

 
320,231

Derivative assets
 
 
 
 
 
 
 
U.S. Treasury futures
2,495

 
—

 
—

 
2,495

Forward agency and loan sales
—

 
3,298

 
—

 
3,298

Rate lock commitments
—

 
—

 
21,276

 
21,276

Interest rate swaps
—

 
2,386

 
—

 
2,386

Total derivative assets
2,495

 
5,684

 
21,276

 
29,455

Total assets at fair value
$
1,197,561

 
$
1,412,745

 
$
553,642

 
$
3,163,948

Derivative liabilities
 
 
 
 
 
 
 
Agency forwards
$
(97
)
 
$
—

 
$
—

 
$
(97
)
Interest rate swaps
—

 
(2,386
)
 
—

 
(2,386
)
Total derivative liabilities
(97
)
 
(2,386
)
 
—

 
(2,483
)
Warrant liabilities
—

 
(11,577
)
 
—

 
(11,577
)
Long-term debt
—

 
—

 
(101,710
)
 
(101,710
)
Litigation settlement
—

 
—

 
(94,000
)
 
(94,000
)
Total liabilities at fair value
$
(97
)
 
$
(13,963
)
 
$
(195,710
)
 
$
(209,770
)
 
 
 
 
 
 
 
 

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Level 1
 
Level 2
 
Level 3
 
Total  Fair
Value
December 31, 2013
(Dollars in thousands)
Investment securities available-for-sale
 
 
 
 
 
 
 
U.S. government sponsored agencies
$
1,028,248

 
$
—

 
$
—

 
$
1,028,248

Municipal obligations
—

 
17,300

 
—

 
17,300

Loans held-for-sale
 
 
 
 
 
 
 
Residential first mortgage loans
—

 
1,140,507

 
—

 
1,140,507

Loans held-for-investment
 
 
 
 
 
 
 
Residential first mortgage loans
—

 
18,625

 
—

 
18,625

Second mortgage loans
—

 
—

 
64,685

 
64,685

HELOC loans
—

 
—

 
155,012

 
155,012

Mortgage servicing rights
—

 
—

 
284,678

 
284,678

Derivative assets
 
 
 
 
 
 
 
U.S. Treasury futures
1,221

 
—

 
—

 
1,221

Forward agency and loan sales
—

 
19,847

 
—

 
19,847

Rate lock commitments
—

 
—

 
10,329

 
10,329

Interest rate swaps
—

 
1,797

 
—

 
1,797

Total derivative assets
1,221

 
21,644

 
10,329

 
33,194

Total assets at fair value
$
1,029,469

 
$
1,198,076

 
$
514,704

 
$
2,742,249

Derivative liabilities
 
 
 
 
 
 
 
Agency forwards
$
(1,665
)
 
$
—

 
$
—

 
$
(1,665
)
Interest rate swaps
—

 
(1,797
)
 
—

 
(1,797
)
Total derivative liabilities
(1,665
)
 
(1,797
)
 
—

 
(3,462
)
Warrant liabilities
—

 
(10,802
)
 
—

 
(10,802
)
Long-term debt
—

 
—

 
(105,813
)
 
(105,813
)
Litigation settlement
—

 
—

 
(93,000
)
 
(93,000
)
Total liabilities at fair value
$
(1,665
)
 
$
(12,599
)
 
$
(198,813
)
 
$
(213,077
)

A determination to classify a financial instrument within Level 3 of the valuation hierarchy is based upon the significance of the unobservable inputs to the overall fair value measurement. However, Level 3 financial instruments typically include, in addition to the unobservable or Level 3 inputs, observable inputs (that is, inputs 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 in the Level 3 rollforward table 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.

The Company had no transfers of assets or liabilities recorded at fair value between the fair value Levels for the three months ended March 31, 2014 and 2013.


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Table of Contents

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 months ended March 31, 2014 and 2013 (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
 
 
 
 
 
Three Months Ended March 31, 2014
Balance at
Beginning of
Period
Total Unrealized Gains / (Losses)
Total Realized Gains / (Losses)
Total Unrealized Gains / (Losses)
Purchases
Sales
Settlements
Balance at
End of 
Period
Unrealized Gains / (Losses) Held at End of Period (4)
Assets
(Dollars in thousands)
Loans held-for-investment
 
 
 
 
 
 
 
 
 
Second mortgage loans
$
64,685

$
(417
)
$
444

$
—

$
—

$
—

$
(3,172
)
$
61,540

$
27

HELOC loans
155,012

(1,940
)
1,513

—

57

—

(4,047
)
150,595

7,257

Mortgage servicing rights
284,678

(9,592
)
—

—

51,043

(5,898
)
—

320,231

(4,099
)
Derivative financial instruments
 
 
 
 
 
 
 
 
 
Rate lock commitments
10,329

32,989

—

—

59,090

(64,887
)
(16,245
)
21,276

(637
)
          Totals
$
514,704

$
21,040

$
1,957

$
—

$
110,190

$
(70,785
)
$
(23,464
)
$
553,642

$
2,548

Liabilities
 
 
 
 
 
 
 
 
 
Long-term debt
$
(105,813
)
$
—

$
(1,324
)
$
—

$
—

$
—

$
5,427

$
(101,710
)
$
1,321

Litigation settlement
(93,000
)
—

(1,000
)
—

—

—

—

(94,000
)
—

          Totals
$
(198,813
)
$
—

$
(2,324
)
$
—

$
—

$
—

$
5,427

$
(195,710
)
$
1,321

 
 
 
 
 
 
 
 
 
 
Three Months Ended March 31, 2013
 
 
 
 
 
 
 
 
 
Investment securities available-for-sale (1)(2)(3)
 
 
 
 
 
 
 
 
 
Mortgage securitization
$
91,117

$
—

$
—

$
1,227

$
—

$
—

$
(4,988
)
$
87,356

$
—

Loans held-for-investment
 
 
 
 
 
 
 
 
 
Transferors' interest
7,103

(174
)
—

—

—

—

(57
)
6,872

(174
)
Mortgage servicing rights
710,791

(15,641
)
—

—

126,494

(94,437
)
—

727,207

17,540

Derivative financial instruments
 
 
 
 
 
 
 
 
 
Rate lock commitments
86,200

(30,828
)
—

—

139,514

(118,815
)
(24,682
)
51,389

3,230

Totals
$
895,211

$
(46,643
)
$
—

$
1,227

$
266,008

$
(213,252
)
$
(29,727
)
$
872,824

$
20,596

Liabilities
 
 
 
 
 
 
 
 
 
Litigation settlement
$
(19,100
)
$
—

$
—

$
—

$
—

$
—

$
—

$
(19,100
)
$
—

 
 
 
 
 
 
 
 
 
 
(1)
Realized gains (losses), including unrealized losses deemed other-than-temporary and related to credit issues, are reported in noninterest income.
(2)
U.S. government agency investment securities available-for-sale are valued predominantly using quoted broker/dealer prices with adjustments to reflect any assumptions a willing market participant would include in its valuation. Non-agency CMOs investment securities available-for-sale are valued using internal valuation models and pricing information from third parties.
(3)
Reflects the changes in the unrealized gains (losses) related to financial instruments held at the end of the period.


    

18
Table of Contents

The following tables present the quantitative information about recurring Level 3 fair value financial instruments and the fair value measurements as of March 31, 2014 and December 31, 2013.
 
Fair Value
Valuation Technique
Unobservable Input
Range (Weighted Average)
March 31, 2014
(Dollars in thousands)
  Assets
 
Second mortgage loans
$
61,540

Discounted cash flows
Discount rate
Prepay rate - 12 month historical average
CDR rate - 12 month historical average
7.1% - 10.7% (8.9%)
8.8% - 13.1% (11.0%)
2.2% - 3.3% (2.7%)
FSTAR 2005-1 HELOC loans
$
75,998

Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
5.6% - 8.4% (7.0%)
6.4% - 9.6% (8.0%)
11.7% - 17.5% (14.6%)
80.0% - 120.0% (100.0%)
FSTAR 2006-2 HELOC loans
$
74,597

Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
7.2% - 10.8% (9.0%)
8.0% - 12.0% (10.0%)
40.0% - 60.1% (50.1%)
80.0% - 120.0% (100.0%)
Mortgage servicing rights
$
320,231

Discounted cash flows
Option adjusted spread
Constant prepayment rate
Weighted average cost to service per loan
7.6% - 11.3% (9.4%)
7.5% - 10.9% (9.3%)
59.0% - 88.5% (73.8%)
Rate lock commitments
$
21,276

Consensus pricing
Origination pull-through rate
65.7% - 98.5% (82.1%)
  Liabilities
 
 
 
 
FSTAR 2005-1 Long-term debt
$
(53,354
)
Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
5.6% - 8.4% (7.0%)
6.4% - 9.6% (8.0%)
11.7% - 17.5% (14.6%)
80.0% - 120.0% (100.0%)
FSTAR 2006-2 Long-term debt
$
(48,356
)
Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
7.2% - 10.8% (9.0%)
8.0% - 12.0% (10.0%)
40.0% - 60.1% (50.1%)
80.0% - 120.0% (100.0%)
Litigation settlement
$
(94,000
)
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%)

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Table of Contents

 
Fair Value
Valuation Technique
Unobservable Input
Range (Weighted Average)
December 31, 2013
(Dollars in thousands)
  Assets
 
Second mortgage loans
$
64,685

Discounted cash flows
Discount rate
Prepay rate - 12 month historical average
CDR rate - 12 month historical average
7.1% - 10.7% (8.9%)
10.5% - 15.7% (13.1%)
2.2% - 3.2% (2.7%)
FSTAR 2005-1 HELOC loans
$
78,009

Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
5.6% - 8.4% (7.0%)
12.8% - 19.2% (16.0%)
11.6% - 17.4% (14.5%)
80.0% - 120.0% (100.0%)
FSTAR 2006-2 HELOC loans
$
77,003

Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
7.2% - 10.8% (9.0%)
9.6% - 14.4% (12.0%)
39.9% - 59.8% (49.9%) 80.0% - 120.0% (100.0%)
Mortgage servicing rights
$
284,678

Discounted cash flows
Origination adjusted spread
Constant prepayment rate
Weighted average cost to service per loan
5.9% - 8.9% (7.7%)
9.7% - 14.0% (11.9%)
59.1% - 88.6% (73.8%)
Rate lock commitments
$
10,329

Consensus pricing
Origination pull-through rate
65.9% - 98.8% (82.3%)
  Liabilities
 
 
 
 
FSTAR 2005-1 Long-term debt
$
(55,172
)
Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
5.6% - 8.4% (7.0%)
12.8% - 19.2% (16.0%)
11.6% - 17.4% (14.5%)
80.0% - 120.0% (100.0%)
FSTAR 2006-2 Long-term debt
$
(50,641
)
Discounted cash flows
Discount rate
Prepay rate - 3 month historical average
Cumulative loss rate
Loss severity
7.2% - 10.8% (9.0%)
9.6% - 14.4% (12.0%)
39.9% - 59.9% (49.9%) 80.0% - 120.0% (100.0%)
Litigation settlement
$
(93,000
)
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 second mortgage loans associated with the FSTAR 2006-1 mortgage securitization trust are discount rates, prepayment rates and default rates. 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 HELOC loans and long-term debt associated with the FSTAR 2005-1 and FSTAR 2006-2 securitization trusts 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 (decreases) in prepay rates in isolation would result in a higher (lower) fair value measurement while increases (decreases) in loss rates in isolation would result in a lower (higher) fair value. 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 the 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 DOJ litigation settlement are future balance sheet and growth rate assumptions for overall asset growth, MSR growth, peer group return on assets and return on

20
Table of Contents

assets improvement. The current assumptions are based on management's approved, strategic performance targets beyond the current strategic modeling horizon (2014). The Bank's target asset growth rate post 2014 is based off of growth in the balance sheet. Significant increases (decreases) in the bank's growth rate in isolation would result in a significantly lower (higher) fair value measurement. Significant increases (decreases) in the bank'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 (decreases) in the bank's return on assets improvement in isolation would result in a marginally higher (lower) fair value measurement.

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 fair value 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
 
 
Level 3
 
 
(Dollars in thousands)
March 31, 2014
 
 
Impaired loans held-for-investment (1)
 
 
Residential first mortgage loans
 
$
50,585

Commercial real estate loans
 
1,500

Repossessed assets (2)
 
31,076

Totals
 
$
83,161

December 31, 2013
 
 
Impaired loans held-for-investment (1)
 
 
Residential first mortgage loans
 
$
68,252

Commercial real estate loans
 
1,500

Repossessed assets (2)
 
36,636

Totals 
 
$
106,388

 
(1)
The Company recorded $9.9 million and $37.5 million in fair value losses on impaired loans (included in provision for loan losses on the Consolidated Statements of Operations) during the three months ended March 31, 2014 and 2013, respectively.
(2)
The Company recorded $0.5 million and $0.8 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 $0.8 million and $4.4 million on sales of repossessed assets (both write-downs and net gains/losses are included in asset resolution expense on the Consolidated Statements of Operations) during the three months ended March 31, 2014 and 2013, respectively.

The following tables present the quantitative information about non-recurring Level 3 fair value financial instruments and the fair value measurements as of March 31, 2014 and December 31, 2013.
 
Fair Value
Valuation Technique
Unobservable Input
Range (Weighted Average)
March 31, 2014
(Dollars in thousands)
Impaired loans held-for-investment
 
 
 
 
     Residential first mortgage loans
$
50,585

Fair value of collateral
Loss severity discount
0% - 100% (46.2%)
     Commercial real estate loans
$
1,500

Fair value of collateral
Loss severity discount
0% - 100% (39.6%)
Repossessed assets
$
31,076

Fair value of collateral
Loss severity discount
0% - 100% (44.9%)
 
Fair Value
Valuation Technique
Unobservable Input
Range (Weighted Average)
December 31, 2013
(Dollars in thousands)
Impaired loans held-for-investment
 
 
 
 
     Residential first mortgage loans
$
68,252

Fair value of collateral
Loss severity discount
0% - 100% (44.9%)
     Commercial real estate loans
$
1,500

Fair value of collateral
Loss severity discount
0% - 100% (39.6%)
Repossessed assets
$
36,636

Fair value of collateral
Loss severity discount
0% - 100% (45.3%)
    

21
Table of Contents

The Company has certain impaired residential first mortgage 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 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.


22
Table of Contents

The following table presents the carrying amount and estimated fair value of certain financial instruments that are carried either at fair value or cost. 
 
March 31, 2014
 
 
 
Estimated Fair Value
 
Carrying
Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(Dollars in thousands)
Financial Instruments
 
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
56,968

 
$
56,968

 
$
56,968

 
$
—

 
$
—

Investment securities available-for-sale
1,207,430

 
1,207,430

 
1,195,066

 
12,364

 
—

Loans held-for-sale
1,673,763

 
1,676,432

 
—

 
1,676,432

 
—

Loans repurchased with government guarantees
1,266,702

 
1,229,970

 
—

 
1,229,970

 
—

Loans held-for-investment, net
3,712,871

 
3,616,402

 
—

 
21,719

 
3,594,683

Repossessed assets
31,076

 
31,076

 
—

 
—

 
31,076

Federal Home Loan Bank stock
209,737

 
209,737

 
209,737

 
—

 
—

Mortgage servicing rights
320,231

 
320,231

 
—

 
—

 
320,231

Customer initiated derivative interest rate swaps
2,386

 
2,386

 
—

 
2,386

 
—

Liabilities
 
 
 
 
 
 
 
 
 
Retail deposits
 
 
 
 
 
 
 
 
 
Demand deposits and savings accounts
(4,027,068
)
 
(3,883,336
)
 
—

 
(3,883,336
)
 
—

Certificates of deposit
(959,241
)
 
(966,493
)
 
—

 
(966,493
)
 
—

Government deposits
(731,192
)
 
(724,124
)
 
—

 
(724,124
)
 
—

Wholesale deposits
(275
)
 
(235
)
 
—

 
(235
)
 
—

Company controlled deposits
(592,525
)
 
(586,501
)
 
—

 
(586,501
)
 
—

Federal Home Loan Bank advances
(1,125,000
)
 
(1,124,931
)
 
(1,124,931
)
 
—

 
—

Long-term debt
(349,145
)
 
(195,188
)
 
—

 
(93,478
)
 
(101,710
)
Warrant liabilities
(11,577
)
 
(11,577
)
 
—

 
(11,577
)
 
—

Litigation settlement
(94,000
)
 
(94,000
)
 
—

 
—

 
(94,000
)
Customer initiated derivative interest rate swaps
(2,386
)
 
(2,386
)
 
—

 
(2,386
)
 
—

Derivative Financial Instruments
 
 
 
 
 
 
 
 
 
Forward agency and loan sales
3,298

 
3,298

 
—

 
3,298

 
—

Rate lock commitments
21,276

 
21,276

 
—

 
—

 
21,276

U.S. Treasury and agency futures/forwards
2,398

 
2,398

 
2,398

 
—

 
—



23
Table of Contents

 
 
December 31, 2013
 
 
 
Estimated Fair Value
 
Carrying
Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(Dollars in thousands)
Financial Instruments
 
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
280,505

 
$
280,505

 
$
280,505

 
$
—

 
$
—

Investment securities available-for-sale
1,045,548

 
1,045,548

 
1,028,248

 
17,300

 
—

Loans held-for-sale
1,480,418

 
1,469,820

 
—

 
1,469,820

 
—

Loans repurchased with government guarantees
1,273,690

 
1,212,799

 
—

 
1,212,799

 
—

Loans held-for-investment, net
3,848,756

 
3,653,292

 
—

 
18,625

 
3,634,667

Repossessed assets
36,636

 
36,636

 
—

 
—

 
36,636

Federal Home Loan Bank stock
209,737

 
209,737

 
209,737

 
—

 
—

Mortgage servicing rights
284,678

 
284,678

 
—

 
—

 
284,678

Customer initiated derivative interest rate swaps
1,797

 
1,797

 
—

 
1,797

 
—

Liabilities
 
 
 
 
 
 
 
 
 
Retail deposits
 
 
 
 
 
 
 
 
 
Demand deposits and savings accounts
(3,919,937
)
 
(3,778,890
)
 
—

 
(3,778,890
)
 
—

Certificates of deposit
(1,026,129
)
 
(1,034,599
)
 
—

 
(1,034,599
)
 
—

Government accounts
(602,398
)
 
(596,778
)
 
—

 
(596,778
)
 
—

Wholesale deposits
(8,717
)
 
(8,716
)
 
—

 
(8,716
)
 
—

Company controlled deposits
(583,145
)
 
(577,662
)
 
—

 
(577,662
)
 
—

Federal Home Loan Bank advances
(988,000
)
 
(988,102
)
 
(988,102
)
 
—

 
—

Long-term debt
(353,248
)
 
(202,887
)
 
—

 
(97,074
)
 
(105,813
)
Warrant liabilities
(10,802
)
 
(10,802
)
 
—

 
(10,802
)
 
—

Litigation settlement
(93,000
)
 
(93,000
)
 
—

 
—

 
(93,000
)
Customer initiated derivative interest rate swaps
(1,797
)
 
(1,797
)
 
—

 
(1,797
)
 
—

Derivative Financial Instruments
 
 
 
 
 
 
 
 
 
Forward agency and loan sales
19,847

 
19,847

 
—

 
19,847

 
—

Rate lock commitments
10,329

 
10,329

 
—

 
—

 
10,329

U.S. Treasury and agency futures/forwards
(444
)
 
(444
)
 
(444
)
 
—

 
—


The methods and assumptions used by the Company in estimating fair value of financial instruments that were not previously disclosed, are as follows:

Cash and cash equivalents. Due to their short-term nature, the carrying amount of cash and cash equivalents approximates fair value.

Loans repurchased with government guarantees. The fair value of loans is estimated by using internally developed discounted cash flow models using market interest rate inputs as well as management’s best estimate of spreads for similar collateral.

Loans held-for-investment. The fair value of loans is estimated by using internally developed discounted cash flow models using market interest rate inputs as well as management’s best estimate of spreads for similar collateral.

Federal Home Loan Bank stock. No secondary market exists for Federal Home Loan Bank stock. The stock is bought and sold at par by the Federal Home Loan Bank. Management believes that the recorded value is the fair value.


24
Table of Contents

Deposit accounts. The fair value of demand deposits and savings accounts approximates the carrying amount. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for certificates of deposit with similar remaining maturities.

Federal Home Loan Bank advances. Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of the existing debt.

Long-term debt. The fair value of the long-term debt is estimated based on a discounted cash flow model that incorporates the Company’s current borrowing rates for similar types of borrowing arrangements.

Fair Value Option

The Company elected to measure at fair value certain financial assets and financial liabilities. The Company elected fair value option for the following items to mitigate a divergence between accounting losses and economic exposure.

The Company elected the fair value option for held-for-sale loans, originated post 2009, and the litigation settlement liability to better reflect the management of these financial instruments on a fair value basis. Loan held-for-investment include loans that were originated as loans held-for-sale and later transferred to loans held-for-investment at fair value. Interest income on loans held-for-sale is accrued on the principal outstanding primarily using the "simple-interest" method. Interest expense on the litigation settlement will be included in the overall change in fair value of the liability each quarter. Direct loan origination cost and fees on loans held-for-sale are recognized in income at origination.

As of June 30, 2013, the Company dissolved the FSTAR 2006-1 mortgage securitization trust and transferred the second mortgage loans, underlying the collapsed FSTAR 2006-1 mortgage securitization which were carried at fair value in available-for-sale investment securities. The change in fair value relating to the loans is recorded in other noninterest income.

As of June 30, 2013, the Company elected the fair value option for the assets and liabilities of reconsolidated VIEs related to the HELOC securitization trusts. This option is generally elected for newly consolidated VIEs for which predominantly all of the Company's interests, prior to consolidation, are carried at fair value with changes in fair value recorded to earnings. The change in fair value relating to the assets and liabilities of these transactions is recorded in other noninterest income. Accordingly, such an election allows the Company to continue fair value accounting through earnings for those interests and eliminate income statement mismatch otherwise caused by differences in the measurement basis of the consolidated VIEs assets and liabilities.

The Company elected the fair value option to account for the liability representing the obligation to make Additional Payments under the DOJ Agreement. The signed DOJ Agreement 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 following table reflects the change in fair value included in earnings (and the account recorded in) for the assets and liabilities for which the fair value option has been elected.
 
 
Three Months Ended March 31,
 
 
2014
 
2013
Assets
(Dollars in thousands)
Loans held-for-sale
 
 
 
 
Net gain on loan sales
$
63,001

 
$
87,643

Loans held-for-investment
 
 
 
 
Interest income on loans
$
—

 
$
(779
)
 
Other noninterest income
(4,269
)
 
—

Liabilities
 
 
 
Long-term debt
 
 
 
 
Other noninterest income
$
4,107

 
$
—

Litigation settlement
 
 
 
 
Legal and professional expense
$
(1,000
)
 
$
—



25
Table of Contents

The following table reflects the difference between the aggregate fair value and aggregate remaining contractual principal balance outstanding as of March 31, 2014 and December 31, 2013 for assets and liabilities for which the fair value option has been elected.
 
 
March 31, 2014
 
December 31, 2013
 
 
(Dollars in thousands)
 


Unpaid Principal Balance
Fair Value
Fair Value Over / (Under) Unpaid Principal Balance
Unpaid Principal Balance
Fair Value
Fair Value Over / (Under) Unpaid Principal Balance
Assets
 
 
 
 
 
 
 
Nonaccrual loans
 
 
 
 
 
 
 
Loans held-for-sale
$
—

$
—

$
—

 
$
—

$
—

$
—

    Loans held-for-investment
9,769

3,748

(6,021
)
 
10,764

4,014

(6,750
)
Total non-accrual loans
$
9,769

$
3,748

(6,021
)
 
$
10,764

$
4,014

$
(6,750
)
    Other performing loans
 
 
 
 
 
 
 
    Loans held-for-sale
$
1,321,719

$
1,372,978

$
51,259

 
$
1,109,517

$
1,140,507

$
30,990

    Loans held-for-investment
252,840

230,106

(22,734
)
 
257,665

234,308

(23,357
)
Total other performing loans
$
1,574,559

$
1,603,084

$
28,525

 
$
1,367,182

$
1,374,815

$
7,633

    Total loans
 
 
 
 
 
 
 
    Loans held-for-sale
$
1,321,719

$
1,372,978

$
51,259

 
$
1,109,517

$
1,140,507

$
30,990

    Loans held-for-investment
262,609

233,854

(28,755
)
 
268,429

238,322

(30,107
)
Total loans
$
1,584,328

$
1,606,832

$
22,504

 
$
1,377,946

$
1,378,829

$
883

Liabilities
 
 
 
 
 
 
 
      Long-term debt
$
(111,077
)
$
(101,710
)
$
(9,367
)
 
$
(116,504
)
$
(105,813
)
$
(10,691
)
      Litigation settlement
N/A (1)
(94,000
)
N/A (1)
 
N/A (1)
(93,000
)
N/A (1)
(1)
Remaining principal outstanding is not applicable to the litigation settlement because it does not obligate the Company to return a stated amount of principal at maturity, but instead return an amount based upon performance on the underlying terms in the Agreement.

Note 4 – Investment Securities

As of March 31, 2014 and December 31, 2013, investment securities were comprised of the following.
 
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
 
(Dollars in thousands)
March 31, 2014
 
 
 
 
 
 
 
 
Available-for-sale securities
 
 
 
 
 
 
 
 
U.S. government sponsored agencies
 
$
1,198,397

 
$
2,790

 
$
(6,121
)
 
$
1,195,066

Municipal obligations
 
12,364

 
—

 
—

 
12,364

Total available-for-sale securities
 
$
1,210,761

 
$
2,790

 
$
(6,121
)
 
$
1,207,430

December 31, 2013
 
 
 
 
 
 
 
 
Available-for-sale securities
 
 
 
 
 
 
 
 
U.S. government sponsored agencies
 
$
1,037,289

 
$
1,546

 
$
(10,587
)
 
$
1,028,248

Municipal obligations
 
17,300

 
—

 
—

 
17,300

Total available-for-sale securities
 
$
1,054,589

 
$
1,546

 
$
(10,587
)
 
$
1,045,548


Available-for-sale securities

Securities available-for-sale are carried at fair value, with unrealized gains and losses reported as a component of other comprehensive loss to the extent they are temporary in nature. Credit related declines in the securities are classified as other-than-temporary impairments ("OTTI") and are reported as a separate component of noninterest income within the Consolidated Statement of Operations. OTTI is considered to have occurred if (1) if the Company intends to sell the security; (2) if it is more

26
Table of Contents

likely than not the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of expected cash flows is not sufficient to recover all contractually required principal and interest payments.

The Company purchased $206.9 million and zero U.S. government sponsored agencies during the three months ended March 31, 2014 and 2013, respectively. There were no municipal obligations purchased during the three months ended March 31, 2014 and 2013, respectively.

The Company has pledged available-for-sale securities, primarily U.S. government sponsored agencies, to collateralize lines of credit and/or borrowings with Fannie Mae. At March 31, 2014, the Company pledged $4.1 million of available-for-sale securities, compared to $7.8 million at December 31, 2013.

The following table summarizes by duration the unrealized loss positions on investment securities available-for-sale. 
 
Unrealized Loss Position with
Duration 12 Months and Over
 
Unrealized Loss Position with
Duration Under 12 Months
  
Fair Value
 
Number of
Securities
 
Unrealized
Loss
 
Fair
Value
 
Number of
Securities
 
Unrealized