ACRES Commercial Realty Corp. - 10-K filing on 2016-03-10

FAIR VALUE OF FINANCIAL INSTRUMENTS

12 Months Ended

Dec. 31, 2015

NOTE 21 - FAIR VALUE OF FINANCIAL INSTRUMENTS

In analyzing the fair value of its investments accounted for on a fair value basis, the Company uses the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company determines fair value based on quoted prices when available or, if quoted prices are not available, through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment. The hierarchy followed defines three levels of inputs that may be used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets and liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset and liability or can be corroborated with observable market data for substantially the entire contractual term of the asset or liability.

Level 3 - Unobservable inputs that reflect the entity’s own assumptions about the assumptions that market participants would use in the pricing of the asset or liability and are consequently not based on market activity, but rather through particular valuation techniques.

The determination of where an asset or liability falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter; depending on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be rare.

Certain assets and liabilities are measured at fair value on a recurring basis. The following is a discussion of these assets and liabilities as well as the valuation techniques applied to each for fair value measurement.

The Company reports its investment securities, available-for-sale at fair value. To determine fair value, the Company uses an independent third-party valuation firm utilizing data available in the market as well as appropriate prepayment, default, and recovery rates. These valuations are validated utilizing dealer quotes, bids, or internal models. If there is a material difference between the value indicated by the third-party valuation firm and the dealer quote or bid, the Company will evaluate the difference, which could result in an updated valuation from the third party or a revised dealer quote. Any changes in the fair value of investment securities, available-for-sale are recorded in other comprehensive income. Based on a prioritization of inputs used in the valuation of each position, the Company categorizes these investments as either Level 2 or Level 3 in the fair value hierarchy.

The Company reports its investment securities, trading at fair value, based on an independent third-party valuation. The Company evaluates the reasonableness of the valuation it receives by using a dealer quote, bid, or internal model. If there is a material difference between the value indicated by the third party and a quote the Company receives, the Company will evaluate the difference, which could result in an updated valuation from the third party or a revised dealer quote. Any changes in fair value are recorded in the Company’s results of operations as net unrealized and unrealized (loss) gain on investment securities, trading. The Company's investments securities, trading are generally classified as Level 2 or Level 3 in the fair value hierarchy.

The CMBS underlying the Company’s linked transactions were valued using the same techniques as those used for the Company’s other investment securities, available-for-sale and were generally classified as Level 2 or Level 3 in the fair value hierarchy. Due to a change in accounting guidance, as of January 1, 2015, the concept of linked transactions no longer exists.

Derivatives, both assets and liabilities, are reported at fair value, and are valued by a third-party pricing agent using an income approach with models that use, as their primary inputs, readily observable market parameters. This valuation process considers factors including interest rate yield curves, time value, credit factors and volatility factors. Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by the Company and its counterparties. The Company assesses the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and, if material, categorizes those derivatives within Level 3 of the fair value hierarchy.

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value as follows (in thousands):



	Level 1		Level 2		Level 3		Total
As of December 31, 2015:
Assets:
Investment securities, trading	$	—	$	—	$	25,550	$	25,550
Investment securities available-for-sale	—		4,451		203,637		208,088
Loans held for sale	—		66,588		29,358		95,946
Derivatives	—		826		2,620		3,446
Total assets at fair value	$	—	$	71,865	$	261,165	$	333,030

Liabilities:
Derivatives	$	—	$	—	$	3,941	$	3,941
Total liabilities at fair value	$	—	$	—	$	3,941	$	3,941

As of December 31, 2014:
Assets:
Investment securities, trading	$	—	$	—	$	20,786	$	20,786
Investment securities available-for-sale	—		33,158		242,562		275,720
CMBS - linked transactions	—		—		15,367		15,367
Derivatives	3,429		7		1,868		5,304
Total assets at fair value	$	3,429	$	33,165	$	280,583	$	317,177

Liabilities:
Moselle CLO Notes	$	—	$	—	$	68,940	$	68,940
Derivatives (net)	—		—		8,476		8,476
Total liabilities at fair value	$	—	$	—	$	77,416	$	77,416

The Company's residential mortgage loan portfolio included in loans held for sale is comprised of both agency loans and non-agency jumbo loans. The fair values of the Company's agency loan portfolio are generally classified as Level 2 in the fair value hierarchy, as those values are determined based on quoted market prices for similar assets or upon other observable inputs. The fair values of the Company's jumbo loan portfolio are generally classified as Level 3 in the fair value hierarchy, as those values are generally based upon valuation techniques that utilize unobservable inputs that reflect the assumptions that a market participant would use in pricing those assets.

For the year ended December 31, 2014, the Company both acquired and liquidated the assets in Moselle CLO. As of December 31, 2014, all that remained of the Company's investment in Moselle CLO were cash, receivables related to the liquidation of Moselle CLO's assets, and the notes of the securitization (see Note 13 for further discussion of Moselle CLO's notes). At acquisition, the Company recorded $176.9 million as the fair value of the notes (including the fair value of the securitized borrowing described in Note 13). During the year ended December 31, 2014, paydowns of $100.3 million were received, and net fair value and foreign currency adjustments of $7.5 million were recognized through earnings, resulting in a combined fair value of $68.9 million ($63.3 million of which was attributable to Moselle CLO's senior notes and $5.6 million was attributable to Moselle CLO's securitized borrowings). As of December 31, 2015, Moselle CLO paid off all of its outstanding CLO notes.

The following table presents additional information about assets that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs (in thousands):



	CMBS ⁽¹⁾			ABS			Structured Finance			Warrants		Interest Rate Lock Commitments			Loans Held for Sale			Total
Balance, January 1, 2015	$	185,772		$	72,157		$	20,786		$	898	$	970		$	83,380		$	363,963
Included in earnings	2,107			2,051			2,403			153		30,028			(1,248		)	35,494
Unlinked transaction	33,239			—			—			—		—			—			33,239
Purchases originations	12,374			24,811			25,185			—		—			274,623			336,993
Sales	(3,000		)	(27,800		)	(17,282		)	—		—			(321,231		)	(369,313		)
Paydowns	(67,933		)	(9,048		)	(2,432		)	—		—			(6,320		)	(85,733		)
Issuances	—			—			—			—		—			—			—
Settlements	—			(11,216		)	—			—		(29,777		)	—			(40,993		)
Capitalized Interest	—			1,857			—			—		—			—			1,857
Included in OCI	(3,135		)	(12,471		)	(3,110		)	—		—			—			(18,716		)
Transfers into Level 3	—			3,872			—			—		—			154			4,026
Balance, December 31, 2015	$	159,424		$	44,213		$	25,550		$	1,051	$	1,221		$	29,358		$	260,817


(1)	Beginning balance includes linked transactions. Due to a change in accounting guidance, as of January 1, 2015, the concept of linked transactions no longer exists.

The following table presents additional information about liabilities that are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs (in thousands):



	Interest Rate Swaps			Forwards - Residential Mortgage Loans			Total
Balance, January 1, 2015	$	8,680		$	1,029		$	9,709
Included in earnings	(275		)	2,197			1,922
Settlements	—			(2,744		)	(2,744		)
Included in OCI	(4,946		)	—			(4,946		)
Transfers into Level 3	—			—			—
Balance, December 31, 2015	$	3,459		$	482		$	3,941

The following table summarizes financial assets and liabilities measured at fair value on a nonrecurring basis and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value as follows (in thousands):



	Level 1		Level 2		Level 3		Total
As of December 31, 2015:
Assets:
Loans held for sale	$	—	$	1,279	$	153	$	1,432
Impaired loans	—		262		129,433		129,695
Total assets at fair value	$	—	$	1,541	$	129,586	$	131,127

As of December 31, 2014:
Assets:
Loans held for sale	$	—	$	36,956	$	—	$	36,956
Impaired loans	—		1,678		137,811		139,489
Total assets at fair value	$	—	$	38,634	$	137,811	$	176,445

Loans held for sale consist of bank loans and CRE loans identified for sale due to credit concerns. Interest on loans held for sale is recognized according to the contractual terms of the loan and included in interest income on loans. The fair value of bank loans held for sale and impaired bank loans is based on what secondary markets are currently offering for these loans. As such, the Company classifies these loans as nonrecurring Level 2. For the Company’s CRE loans where there is no primary market, fair value is measured using discounted cash flow analysis and other valuation techniques and these loans are classified as nonrecurring Level 3. The amount of nonrecurring fair value losses for specifically impaired loans for the years ended December 31, 2015, 2014 and 2013 was $39.2 million, $1.3 million and $3.1 million respectively. The amounts of nonrecurring fair value losses for loans held for sale for the years ended December 31, 2015, 2014 and 2013 was $1.3 million, $680,000, and $3.9 million.

The Company had $372,000, $0 and $863,000 of losses included in earnings due to the other-than-temporary impairment charges during the years ended December 31, 2015, 2014 and 2013, respectively. These losses were included in the consolidated statements of operations as net impairment losses recognized in earnings.

In accordance with guidance on fair value measurements and disclosures, the Company is not required to disclose quantitative information with respect to unobservable inputs contained in fair value measurements that are not developed by the Company. As a consequence, the Company has not disclosed such information associated with fair values obtained from third-party pricing sources.

For Level 3 assets and liabilities measured at fair value on a recurring or non-recurring basis as of December 31, 2015, for which quantitative information with respect to unobservable inputs was available, the significant unobservable inputs used in the fair value measurements were as follows (in thousands, except were otherwise indicated):



	Fair Value at December 31, 2015		Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Value
Interest rate swap agreements	$	3,459	Discounted cash flow	Weighted average credit spreads	5.38		%
Warrant	$	1,051	Option pricing model	Market capitalization (in millions)	$	172.7
				Volatility	50.0		%

The Company is required to disclose the fair value of financial instruments for which it is practicable to estimate that value. The fair values of the Company's short-term financial instruments such as cash and cash equivalents, restricted cash, principal paydown receivable, interest receivable, distribution payable and accrued interest expense, repurchase agreements and the secured revolving credit agreement approximate their carrying value on the consolidated balance sheets. The fair values of the Company’s investment securities, trading is reported in Note 6. The fair values of the Company’s investment securities available-for-sale are reported in Note 7. The fair values of the Company’s derivative instruments and linked transactions are reported in Note 22.

Loans held-for-investment: The fair value of the Company’s Level 2 Loans held-for-investment was primarily measured using a third-party pricing service. The fair value of the Company’s Level 3 Loans held-for-investment was measured by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Loans receivable-related party are estimated by discounting the expected future cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

CDO notes are valued using the dealer quotes, typically the dealer who underwrote the CDO in which the notes are held.

Junior subordinated notes are estimated by obtaining quoted prices for similar assets in active markets.

The fair value of the convertible notes was determined using a discounted cash flow model that discounts the expected future cash flows using current interest rates on similar debts that do not have a conversion option. The 6% Convertible Senior Notes are discounted at a rate of 7.00% and the 8% Convertible Senior Notes are discounted at a rate of 8.60%. The fair value of the CRE portfolio was determined using a discounted cash flow model that discounts the expected future cash flows at current rates at which similar loans would be made to borrowers with similar credit rating and with the same remaining maturities. Discount rates used range between 15%-25%.

The fair values of the Company’s remaining financial instruments that are not reported at fair value on the consolidated balance sheets are reported below (in thousands):



			Fair Value Measurements
	Carrying Amount		Fair Value		Quoted Prices in Active Markets for Identical Assets of Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
As of December 31, 2015:
Loans held-for-investment	$	2,160,751	$	2,150,061	$	—	$	222,100	$	1,927,961
CDO notes	$	1,032,581	$	923,817	$	—	$	—	$	923,817
Junior subordinated notes	$	51,413	$	17,907	$	—	$	—	$	17,907
Convertible notes	$	205,484	$	205,484	$	—	$	—	$	205,484
Repurchase agreements	$	418,836	$	418,836	$	—	$	—	$	418,836
Senior secured revolving credit agreement	$	186,974	$	186,974	$	—	$	—	$	186,974

As of December 31, 2014:
Loans held-for-investment	$	1,925,980	$	1,909,019	$	—	$	570,071	$	1,338,948
Loans receivable-related party	$	558	$	558	$	—	$	—	$	558
CDO notes	$	1,046,493	$	975,762	$	—	$	—	$	975,762
Junior subordinated notes	$	51,205	$	17,699	$	—	$	—	$	17,699
Convertible notes	$	108,374	$	108,374	$	—	$	—	$	108,374
Repurchase agreements	$	399,662	$	399,662	$	—	$	—	$	399,662
Senior secured revolving credit agreement	$	111,137	$	111,137	$	—	$	—	$	111,137