Ocwen Financial Corporation
OCWEN FINANCIAL CORP (Form: 10-Q, Received: 11/04/2010 17:27:52)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
  For the quarterly period ended September 30, 2010
   
or
 
o
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: 1-13219
 
Ocwen Financial Corporation
(Exact name of registrant as specified in its charter)
     
Florida
 
65-0039856
(State or other jurisdiction
 
(I.R.S. Employer
of incorporation or organization)
 
Identification No.)
     
1661 Worthington Road, Suite 100, West Palm Beach, Florida 33409
(Address of principal executive offices) (Zip Code)
     
(561) 682-8000
(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 90 days.
Yes x     No o
 
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o     No o
 
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.
 
Large accelerated filer
o
Accelerated filer
x
Non-accelerated filer
o (Do not check if a smaller reporting company)
Smaller reporting company
o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes o     No x
 
Number of shares of Common Stock, $0.01 par value, outstanding as of October 31, 2010: 100,496,378 shares.

 
 

 
 
OCWEN FINANCIAL CORPORATION
 
FORM 10-Q
 
INDEX
 

 

   
PAGE
   
       
3
 
       
 
3
 
       
 
4
 
 
 
   
 
5
 
       
 
6
 
       
 
7
 
       
 
9
 
       
42
 
       
61
 
       
62
 
       
   
       
62
 
       
62
 
       
Item 5.
Other Information
 
 
       
64
 
       
66
 
 
 
1

 
 
FORWARD-LOOKING STATEMENTS
 
This Quarterly Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, but not limited to the following:
 
 
·
assumptions related to the sources of liquidity, our ability to fund advances and the adequacy of financial resources;
     
 
·
estimates regarding prepayment speeds, float balances, delinquency rates, advances and other servicing portfolio characteristics;
     
 
·
assumptions about our ability to grow our business;
     
 
·
our plans to continue to sell our non-core assets;
     
 
·
our ability to reduce our cost structure;
     
 
·
our continued ability to successfully and timely modify delinquent loans, foreclose on delinquent loans and sell foreclosed properties;
     
 
·
estimates regarding our reserves, valuations and anticipated realization on assets; and
     
 
·
expectations as to the effect of resolution of pending legal proceedings on our financial condition.
 
Forward-looking statements are not guarantees of future performance and involve a number of assumptions, risks and uncertainties that could cause actual results to differ materially. Important factors that could cause actual results to differ include, but are not limited to, the risks discussed in “Risk Factors” below and the following:
 
 
·
availability of adequate and timely sources of liquidity;
     
 
·
delinquencies, advances and availability of servicing;
     
 
·
general economic and market conditions;
     
 
·
uncertainty related to the actions of loan owners, including mortgage-backed securities investors, regarding loan putbacks and other servicing practices;
     
 
·
uncertainty related to the processes for judicial and non-judicial foreclosure proceedings , including potential additional costs or delays in the future or claims pertaining to past practices;
     
 
·
uncertainty related to government programs, regulations and policies; and
     
 
·
uncertainty related to dispute resolution and litigation.
 
Further information on the risks specific to our business are detailed within this report and our other reports and filings with the Securities and Exchange Commission including our Annual report on Form 10-K for the year ended December 31, 2009, our quarterly reports on Form 10-Q and our current reports on Form 8-K. Forward-looking statements speak only as of the date they are made and should not be relied upon. Ocwen Financial Corporation undertakes no obligation to update or revise forward-looking statements.
 
 
2

 
 
PART I – FINANCIAL INFORMATION
ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
 
   
September 30,
2010
   
December 31,
2009
 
Assets
           
Cash
  $ 163,911     $ 90,919  
Restricted cash – for securitization investors
    942        
Trading securities, at fair value:
               
Auction rate
    74,712       247,464  
Subordinates and residuals
          3,692  
Loans held for resale, at lower of cost or fair value
    29,352       33,197  
Advances
    218,936       145,914  
Match funded advances
    2,126,991       822,615  
Loans, net – restricted for securitization investors
    69,736        
Mortgage servicing rights
    203,930       117,802  
Receivables, net
    42,747       67,095  
Deferred tax assets, net
    133,782       132,683  
Goodwill
    19,457        
Premises and equipment, net
    11,893       3,325  
Investments in unconsolidated entities
    12,284       15,008  
Other assets
    147,101       89,636  
Total assets
  $ 3,255,774     $ 1,769,350  
                 
Liabilities and Equity Liabilities
               
Match funded liabilities
  $ 1,606,346     $ 465,691  
Secured borrowings – owed to securitization investors
    64,564        
Lines of credit and other secured borrowings
    444,499       55,810  
Investment line
          156,968  
Servicer liabilities
    2,368       38,672  
Debt securities
    82,554       95,564  
Other liabilities
    166,751       90,782  
Total liabilities
    2,367,082       903,487  
                 
Commitments and Contingencies (Note 25)
               
                 
Equity
               
Ocwen Financial Corporation stockholders’ equity
               
Common stock, $.01 par value; 200,000,000 shares authorized; 100,476,378 and 99,956,833 shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively
    1,005       1,000  
Additional paid-in capital
    465,005       459,542  
Retained earnings
    435,535       405,198  
Accumulated other comprehensive loss, net of income taxes
    (13,104 )     (129 )
Total Ocwen Financial Corporation stockholders’ equity
    888,441       865,611  
Non-controlling interest in subsidiaries
    251       252  
Total equity
    888,692       865,863  
Total liabilities and equity
  $ 3,255,774     $ 1,769,350  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
3

 
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands)
 
For the periods ended September 30,
 
Three months
   
Nine months
 
   
2010
   
2009
   
2010
   
2009
 
Revenue
                       
Servicing and subservicing fees
  $ 86,424     $ 57,534     $ 218,840     $ 201,832  
Process management fees
    7,911       24,594       24,132       98,372  
Other revenues
    1,234       2,083       4,136       7,776  
Total revenue
    95,569       84,211       247,108       307,980  
                                 
Operating expenses
                               
Compensation and benefits
    43,886       18,959       69,752       74,758  
Amortization of mortgage servicing rights
    7,874       7,159       22,103       25,743  
Servicing and origination
    1,707       7,804       4,756       36,277  
Technology and communications
    6,727       5,065       18,582       14,354  
Professional services
    25,132       6,378       37,521       21,772  
Occupancy and equipment
    5,201       4,192       13,517       15,056  
Other operating expenses
    2,847       4,675       6,978       11,188  
Total operating expenses
    93,374       54,232       173,209       199,148  
                                 
Income from operations
    2,195       29,979       73,899       108,832  
                                 
Other income (expense)
                               
Interest income
    2,962       1,992       8,507       6,411  
Interest expense
    (24,187 )     (16,145 )     (50,017 )     (50,108 )
Gain (loss) on trading securities
    (3,013 )     8,291       (3,958 )     13,346  
Loss on loans held for resale, net
    (539 )     (1,242 )     (2,626 )     (8,783 )
Equity in earnings (losses) of unconsolidated entities
    266       (1,059 )     1,344       (1,608 )
Other, net
    1,604       1,642       (3,154 )     4,977  
Other expense, net
    (22,907 )     (6,521 )     (49,904 )     (35,765 )
                                 
Income (loss) from continuing operations before taxes
    (20,712 )     23,458       23,995       73,067  
Income tax expense (benefit)
    (7,487 )     65,294       310       82,803  
Income (loss) from continuing operations
    (13,225 )     (41,836 )     23,685       (9,736 )
Income (loss) from discontinued operations, net of taxes
    4,383       (231 )     4,383       633  
Net income (loss)
    (8,842 )     (42,067 )     28,068       (9,103 )
Net loss (income) attributable to non-controlling interest in subsidiaries
    7       36       (5 )     11  
Net income (loss) attributable to Ocwen Financial Corporation (OCN)
  $ (8,835 )   $ (42,031 )   $ 28,063     $ (9,092 )
                                 
Basic earnings per share
                               
Income (loss) from continuing operations attributable to OCN
  $ (0.13 )   $ (0.51 )   $ 0.24     $ (0.14 )
Income (loss) from discontinued operations attributable to OCN
    0.04             0.04       0.01  
Net income (loss) attributable to OCN
  $ (0.09 )   $ (0.51 )   $ 0.28     $ (0.13 )
                                 
Diluted earnings per share
                               
Income (loss) from continuing operations attributable to OCN
  $ (0.13 )   $ (0.51 )   $ 0.23     $ (0.14 )
Income from discontinued operations attributable to OCN
    0.04             0.04       0.01  
Net income (loss) attributable to OCN
  $ (0.09 )   $ (0.51 )   $ 0.27     $ (0.13 )
                                 
Weighted average common shares outstanding
                               
Basic
    100,329,915       82,614,456       100,159,547       70,966,393  
Diluted
    100,329,915       82,614,456       107,379,725       70,966,393  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
4

 
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
(Dollars in thousands)
 
For the periods ended September 30,
 
Three months
   
Nine months
 
   
2010
   
2009
   
2010
   
2009
 
                         
Net income (loss)
  $ (8,842 )   $ (42,067 )   $ 28,068     $ (9,103 )
                                 
Other comprehensive income (loss), net of income taxes:
                               
                                 
Unrealized foreign currency translation income (loss ) arising during the period (1)
    54       (80 )     (31 )     (307 )
                                 
Change in deferred loss on cash flow hedges arising during the period (2)
    (5,835 )           (13,239 )      
Reclassification adjustment for losses on cash flow hedges included in net income (3)
    268             289        
Net change in deferred loss on cash flow hedges
    (5,567 )           (12,950 )      
                                 
      (5,513 )     (80 )     (12,981 )     (307 )
                                 
Comprehensive income (loss)
    (14,355 )     (42,147 )     15,087       (9,410 )
                                 
Comprehensive (income) loss attributable to
non-controlling interests
    (11 )     47       1       144  
                                 
Comprehensive income (loss) attributable to OCN
  $ (14,366 )   $ (42,100 )   $ 15,088     $ (9,266 )
 
(1)
Net of income tax benefit (expense) of $(8) and $47 for the three months ended September 30, 2010 and 2009, respectively, and $27 and $180 for the nine months ended September 30, 2010 and 2009, respectively.
   
(2)
Net of tax benefit of $3,428 and $7,775, respectively for the three and nine months ended September 30, 2010.
   
(3)
Net of tax expense of $158 and $169, respectively for the three and nine months ended September 30, 2010.
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
5

 
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
(Dollars in thousands, except share data)

   
OCN Shareholders
         
   
Common Stock
 
Additional
Paid-in
 
Retained
 
Accumulated
Other
Comprehensive
Loss,
 
Non-controlling Interest in
     
   
Shares
 
Amount
 
Capital
 
Earnings
 
Net of Taxes
 
Subsidiaries
 
Total
 
                               
Balance at December 31, 2009
  99,956,833   $ 1,000   $ 459,542   $ 405,198   $ (129 ) $ 252   $ 865,863  
Adoption of ASC 810 (FASB Statement No. 167), net of tax
              2,274             2,274  
Net income
              28,063         5     28,068  
Exercise of common stock options
  502,026     5     2,495                 2,500  
Issuance of common stock awards to employees
  9,865                          
Equity-based compensation
  7,654         2,968                 2,968  
Other comprehensive loss, net of income taxes
                  (12,975 )   (6 )   (12,981 )
Balance at September 30, 2010
   100,476,378   $ 1,005    $ 465,005   $ 435,535   $ (13,104 $ 251   $ 888,692  
 
Balance at December 31, 2008
  62,716,530   $ 627   $ 201,831   $ 404,901   $ 1,876   $ 406   $ 609,641  
Net loss
              (9,092 )       (11 )   (9,103 )
Net assets distributed in connection with the spin-off of Altisource Portfolio Solutions S.A. (formerly Ocwen Solutions)
          (71,448 )               (71,448 )
Issuance of common stock
  37,671,500     377     334,790                 335,167  
Repurchase of common stock
  (1,000,000 )   (10 )   (10,990 )               (11,000 )
Exercise of common stock options
  405,013     4     2,964                 2,968  
Issuance of common stock awards to employees
  29,907         (138 )               (138 )
Equity-based compensation
  12,147         1,817                 1,817  
Repurchase of 3.25% Convertible Notes
          (4 )               (4 )
Other comprehensive loss, net of income taxes
                  (307 )   (133 )   (440 )
Balance at September 30, 2009
  99,835,097   $ 998   $ 458,822   $ 395,809   $ 1,569   $ 262   $ 857,460  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
6

 
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
(Dollars in thousands)
 
   
For the nine months ended
September 30,
 
   
2010
   
2009
 
Cash flows from op erating activities
           
Net income (loss)
  $ 28,068     $ (9,103 )
Adjustments to reconcile net income to net cash provided by operating activities
               
Amortization of mortgage servicing rights
    22,103       25,743  
Premium amortization and discount accretion
          1,735  
Depreciation and other amortization
    4,824       7,935  
Write-off of investment in commercial real estate partnership
    3,000        
Reversal of valuation allowance on mortgage servicing assets
    (185 )     (374 )
Reversal of valuation allowance on discontinued operations  
          (1,227 )
Loss (gain) on trading securities
    3,958       (13,346 )
Loss on loans held for resale, net
    2,626       8,783  
Equity in (earnings) losses of unconsolidated entities
    (1,344 )     1,608  
Decrease (increase) in deferred tax assets
    (421 )     44,325  
Net cash provided by trading activities
    168,853       2,500  
Net cash provided by loans held for resale activities
    1,163       3,605  
Changes in assets and liabilities:
               
Decrease in advances and match funded advances
    204,343       187,669  
Decrease (increase) in receivables and other assets, net
    (19,885 )     27,222  
Decrease in servicer liabilities
    (36,304 )     (76,294 )
Increase in other liabilities
    44,912       21,102  
Other, net
    8,871       (2,354 )
Net cash provided by operating activities
    434,582       229,529  
                 
Cash flows from investing activities
               
Purchase of mortgage servicing rights
    (23,425 )     (10,241 )
Acquisition of advances and other assets in connection with the purchase of  mortgage servicing rights
    (528,882 )      
Distributions of capital from unconsolidated entities
    3,542       4,496  
Cash paid to acquire HomEq Servicing (a business within Barclays Bank PLC)
    (1,167,122 )      
Additions to premises and equipment
    (3,261 )     (3,429 )
Proceeds from sales of real estate
    3,001       1,689  
Increase in restricted cash – for securitization investors
    813        
Principal payments received on loans – restricted for securitization investors
    3,558        
Other
          334  
Net cash used by investing activities
    (1,711,776 )     (7,151 )
                 
Cash flows from financing activities
               
Distribution of cash in connection with the Spin-off of Altisource Portfolio Solutions
          (20,028 )
Proceeds from (repayment of) match funded liabilities
    1,140,655       (427,328 )
Repayment of secured borrowings – owed to securitization investors
    (7,487 )      
Proceeds from lines of credit and other secured borrowings
    448,316       102,106  
Repayment of lines of credit and other secured borrowings
    (63,018 )     (151,976 )
Repayment of investment line
    (156,968 )     (33,551 )
Repurchase of debt securities
    (11,659 )     (24,612 )
Repurchase of common stock
          (11,000 )
Issuance of common stock
          335,167  
Exercise of common stock options
    2,381       2,587  
Other
    (2,034 )     1,086  
Net cash provided (used) by financing activities
    1,350,186       (227,549 )
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
7

 
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS – (Continued)
 (Dollars in thousands)

   
For the nine months ended
September 30,
 
   
2010
   
2009
 
Net increase (decrease) in cash
    72,992       (5,171 )
Cash at beginning of period
    90,919       201,025  
Cash at end of period
  $ 163,911     $ 195,854  
                 
Supplemental disclosure of non-cash investing and financing activities:
               
Net assets distributed in connection with the spin-off of Altisource Portfolio  Solutions S.A. (formerly Ocwen Solutions), excluding cash
        $ 51,420  
                 
Supplemental business acquisition information
               
Fair value of assets acquired
               
Advances
  $ (1,062,873 )   $  
Mortgage servicing rights
    (84,683 )      
Premises and equipment
    (8,008 )      
Goodwill
    (19,457 )      
Receivables
    (1,423 )      
      (1,176,444 )      
Fair value of liabilities assumed
               
Other liabilities
    9,322        
Cash paid
    (1,167,122 )      
Less cash acquired
           
Net cash paid
  $ (1,167,122 )   $  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
8

 
 
OCWEN FINANCIAL CORPORATION AND SUBSIDIARIES
SEPTEMBER 30, 2010
(Dollars in thousands, except share data)
 
NOTE 1
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Organization
 
Ocwen Financial Corporation (NYSE: OCN) (Ocwen or OCN), through its subsidiaries, is a leading provider of residential and commercial mortgage loan servicing, special servicing and asset management services. Ocwen is headquartered in West Palm Beach, Florida with offices in California, the District of Columbia, Florida, Georgia and global operations in India and Uruguay. Ocwen is a Florida corporation organized in February 1988. Ocwen Loan Servicing, LLC (OLS), a wholly-owned subsidiary of Ocwen, is a licensed mortgage servicer in all 50 states, the District of Columbia and two U.S. territories.
 
At September 30, 2010, Ocwen owned all of the outstanding stock of its primary subsidiaries: OLS; Ocwen Financial Solutions, Private Limited (OFSPL); and Investors Mortgage Insurance Holding Company. OCN also holds a 25% interest in Ocwen Structured Investments, LLC (OSI) and an approximate 25% interest in Ocwen Nonperforming Loans, LLC (ONL) and Ocwen REO, LLC (OREO). While OCN continues to own 70% of Global Servicing Solutions, LLC (GSS) with the remaining 30% interest held by ML IBK Positions, Inc., GSS had no material operations during the first nine months of 2010 and 2009 and no material assets as of September 30, 2010. Ocwen holds a 45% interest in BMS Holdings, Inc. (BMS Holdings) which had as its principal asset the equity ownership of Bankruptcy Management Solutions, Inc. (BMS). Effective October 1, 2010, BMS Holdings no longer owns any interest in BMS (See Note 26).
 
On August 10, 2009, we completed the distribution of our Ocwen Solutions line of business, except for BMS Holdings and GSS, via the spin-off of a separate publicly-traded company, Altisource Portfolio Solutions S.A. (Altisource). Altisource common stock is listed on the NASDAQ market under the ticker symbol “ASPS.” We distributed all of the shares of Altisource common stock to OCN’s shareholders of record as of August 4, 2009 (the Separation). We eliminated the assets and liabilities of Altisource from our Consolidated Balance Sheet effective at the close of business on August 9, 2009. Beginning August 10, 2009, the operating results of Altisource are no longer included in our operating results. We do not report the historical operating results of Altisource as a discontinued operation because of the significance of the continuing involvement between Altisource and Ocwen under the long-term services agreements described in Note 24. Accordingly, for periods prior to August 10, 2009, the historical operating results of Altisource are presented in continuing operations.
 
On September 1, 2010, Ocwen, through OLS, completed its acquisition (the “HomEq Acquisition”) of the U.S. non-prime mortgage servicing business known as “HomEq Servicing” including, but not limited to, the mortgage servicing rights and associated servicer advances of the business as well as the servicing platforms based in Sacramento, California and Raleigh, North Carolina. See Note 3 for additional information regarding the HomEq Acquisition.
 
Basis of Presentation
 
Certain amounts included in our 2009 consolidated financial statements have been reclassified to conform to the 2010 presentation, including retrospective application of new accounting pronouncements adopted January 1, 2010. See Note 2 for information regarding our adoption of recent accounting pronouncements.
 
The accompanying unaudited interim consolidated financial statements have been prepared in conformity with the instructions of the Securities and Exchange Commission (SEC) to Form 10-Q and SEC Regulation S-X, Article 10, Rule 10-01 for interim financial statements. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (GAAP) for complete financial statements. In our opinion, the accompanying unaudited financial statements contain all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation. The results of operations and other data for the three and nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for any other interim period or for the entire year ending December 31, 2010. The unaudited interim consolidated financial statements presented herein should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2009.
 
The preparation of financial statements in conformity with GAAP requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly significant in the near or medium term relate to our determination of the valuation of securities, loans held for resale, mortgage servicing rights (MSRs), deferred tax assets and goodwill and other components of the HomEq purchase price allocation.
 
 
9

 
 
Principles of Consolidation
 
Our financial statements include the accounts of Ocwen and its majority-owned subsidiaries. We apply the equity method of accounting to investments when the entity is not a variable interest entity (VIE) and we are able to exercise significant influence, but not control, over the policies and procedures of the entity but own less than 50% of the voting securities. We have eliminated intercompany accounts and transactions in consolidation.
 
Variable Interest Entities
 
We evaluate each special purpose entity (SPE) for classification as a VIE. When an SPE meets the definition of a VIE and we determine that Ocwen is the primary beneficiary, we include the SPE in our consolidated financial statements.
 
We have determined that the SPEs created in connection with the match funded financing facilities discussed below are VIEs of which we are the primary beneficiary. We have also determined that we are the primary beneficiary for certain residential mortgage loan securitization trusts. The accounts of these SPEs are included in our consolidated financial statements.
 
Securitizations or Asset Backed Financing Arrangements
 
Ocwen or its subsidiaries have been a transferor in connection with a number of securitizations or asset-backed financing arrangements. As of January 1, 2010, we had continuing involvement with the financial assets of eight of these securitizations or asset-backed financing arrangements. We also hold residual interests in and are the servicer for three securitizations where we were not a transferor.
 
We have aggregated these securitizations and asset-backed financing arrangements into two groups: (1) securitizations of residential mortgage loans and (2) financings of advances on loans serviced for others.
 
Securitizations of Residential Mortgage Loans. In prior years, we securitized residential mortgage loans using certain trusts. These transactions were accounted for as sales even though we continued to be involved with the trusts, typically by acting as the servicer or sub-servicer for the loans held by the trust and by retaining a beneficial ownership interest in the trust. The beneficial interests we held consisted of both subordinate and residual securities that were either retained at the time of the securitization or acquired subsequently.
 
As a result of our adoption of Accounting Standards Update (ASU) No. 2009-16 (ASC 860, Transfers and Servicing) and ASU 2009-17 (ASC 810, Consolidation), we have included four of these trusts in our consolidated financial statements. The remaining trusts are currently excluded from our consolidated financial statements because we have determined that Ocwen is not the primary beneficiary.
 
We have determined that Ocwen is the primary beneficiary of the consolidated securitization trusts because:
 
 
1.
as the servicer we have the right to direct the activities that most significantly impact the economic performance of the trusts through our ability to manage the delinquent assets of the trusts and
     
 
2.
as holder of all or a portion of the residual tranches of the securities issued by the trust, we have the obligation to absorb losses of the trusts, to the extent of the value of our investment, and the right to receive benefits from the trust both of which could potentially be significant to the trusts.
 
Upon adoption of ASU 2009-17 (ASC 810, Consolidation) on January 1, 2010 we began consolidating the four trusts and recorded a $75,506 increase in total assets, a $73,232 increase in liabilities and a $2,274 increase in the opening balance of retained earnings. Included in these amounts were the following transition adjustments:
 
 
·
Consolidation of $1,755 of cash held by the trusts (Restricted cash – for securitization investors);
     
 
·
Consolidation of loans held by the trust with an unpaid principal balance (UPB) of $77,939 (Loans, net – restricted for securitization investors), including $14,780 of non-performing collateral;
     
 
·
Recording of an allowance for loan losses of $4,461, not previously required, for the newly consolidated loans;
     
 
·
Consolidation of $2,346 of real estate owned from the trusts (included in Other assets);
     
 
·
Consolidation of $72,918 of certificates issued by the trusts (Secured borrowings – owed to securitization investors);
 
 
10

 
 
 
·
Elimination of our $3,634 investment in trading securities that were issued by the newly consolidated trusts against $867 of the face amount of the related certificates and retained earnings;
     
 
·
Recording of net deferred tax assets of $1,561, principally related to establishing an allowance for loan losses for the newly consolidated loans; and
     
 
·
Recording of $1,181 of other liabilities representing accrued interest payable and the fair value of interest rate swap instruments entered into by one of the consolidated trusts.
 
The consolidation of the four trusts on January 1, 2010 did not affect Cash and, therefore, the transition adjustments are not reported in the Consolidated Statement of Cash Flows.
 
Our Consolidated Statement of Operations for the three and nine months ended September 30, 2009 and our Consolidated Balance Sheet at December 31, 2009 have not been retroactively adjusted to reflect the effect of our adoption of ASU 2009-16 and ASU 2009-17. Therefore, current period results and balances will not be comparable to prior period amounts particularly with regard to the following:
 
 
·
Trading securities (Subordinates and residuals)
     
 
·
Loans, net – restricted for securitization investors
     
 
·
Deferred tax assets, net
     
 
·
Secured borrowings – owed to securitization investors
     
 
·
Interest income
     
 
·
Interest expense
     
 
·
Gain (loss) on trading securities
 
Beginning January 1, 2010, interest income on the securities that we hold that were issued by the securitization trusts is eliminated in consolidation against the interest expense of the trusts.
 
Ocwen has no obligation to provide financial support to the trusts and has provided no such support. The creditors of the trusts can look only to the assets of the trusts themselves for satisfaction of the debt and have no recourse against the assets of Ocwen. Similarly, the general creditors of Ocwen have no claim on the assets of the trusts. Our exposure to loss as a result of our continuing involvement is limited to the carrying values of our investments in the residual and subordinate securities of the trusts, our mortgage servicing rights that are related to the trusts and our advances to the trusts.
 
The following table presents a summary of the involvement of Ocwen with seven unconsolidated securitization trusts and summary financial information for the trusts. Although we are the servicer for these trusts, the residual interests that we hold in these entities have little to no value. As a result, we are exposed to no loss from these holdings. Further, since our valuation of the residual interest is based on anticipated cash flows, we are unlikely to receive any future benefits from our residual interests in these trusts.
 
For the periods ended September 30,
 
Three months
   
Nine months
 
   
2010
   
2009
   
2010
   
2009
 
Total cash received on beneficial interests held
  $     $ 1     $     $ 63  
Total servicing and subservicing fee revenues
    947       899       2,820       3,102  

   
As of
 
   
September 30, 2010
   
December 31, 2009
 
Total servicing advances
  $ 17,110     $ 19,027  
Total beneficial interests held at fair value (1)
          58  
Total mortgage servicing rights at amortized cost
    1,395       1,659  
 
(1)
Includes investments in subordinate and residual securities that we retained in connection with the loan securitization transactions completed in prior years.
 
 
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With regard to these unconsolidated securitization trusts, we have no obligation to provide financial support to the trusts and have provided no such support. Our exposure to loss as a result of our continuing involvement is limited to the carrying values of our investments in the residual and subordinate securities of the trusts, our mortgage servicing rights that are related to the trusts and our advances to the trusts. We consider the probability of loss arising from our advances to be remote because of their position ahead of most of the other liabilities of the trusts. See Note 5, Note 6, Note 7 and Note 9 for additional information regarding Trading securities, Advances, Match funded advances and Mortgage servicing rights.
 
Match Funded Advances on Loans Serviced for Others. Match funded advances on loans serviced for others result from our transfers of residential loan servicing advances to SPEs in exchange for cash. These SPEs issue debt supported by collections on the transferred advances. We made these transfers under the terms of five advance facility agreements. These transfers do not qualify for sales accounting because we retain control over the transferred assets. As a result, we account for these transfers as financings and classify the transferred advances on our Consolidated Balance Sheet as Match funded advances and the related liabilities as Match funded liabilities. Collections on the advances pledged to the SPEs are used to repay principal and interest and to pay the expenses of the entity. Holders of the debt issued by these entities can look only to the assets of the entities themselves for satisfaction of the debt and have no recourse against OCN. However, OLS has guaranteed the payment of the obligations under the securitization documents of one of the entities, Ocwen Servicer Advance Funding (Wachovia), LLC (OSAFW). The maximum amount payable under the guarantee is limited to 10% of the notes outstanding at the end of the facility’s revolving period on May 5, 2011. As of September 30, 2010, OSAFW had $258,386 of notes outstanding.
 
The following table summarizes the assets and liabilities of the SPEs formed in connection with our match funded advance facilities, at the dates indicated:
 
   
September 30,  2010
   
December 31, 2009
 
Match funded advances
  $ 2,126,991     $ 822,615  
Other assets
    82,211       19,343  
Total assets
  $ 2,209,202     $ 841,958  
                 
Match funded liabilities
  $ 1,606,346     $ 465,691  
Due to affiliates (1)
    106,727       136,860  
Other liabilities
    3,172       1,350  
Total liabilities
  $ 1,716,245     $ 603,901  
 
(1)
Amounts are payable to Ocwen and its consolidated affiliates and eliminated in consolidation.
 
Reclassification
 
Certain immaterial amounts in our 2009 consolidated financial statements have been reclassified to conform to the 2010 presentation. In the fourth quarter of 2009, we reclassified gains and losses on debt redemptions to Other, net on the Consolidated Statements of Operations. On the Consolidated Statements of Changes in Equity, we condensed share-based compensation amounts and associated excess tax benefits into one line item, Equity-based compensation. Within the operating activities section of the Consolidated Statements of Cash Flows we condensed several immaterial items to Other, net. Similarly, in the financing section of the Consolidated Statements of Cash Flows we condensed several immaterial items to Other.
 
NOTE 2
RECENT ACCOUNTING PRONOUNCEMENTS
 
In June 2009, the Financial Accounting Standards Board (FASB) issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles. This establishes the FASB Accounting Standards Codification (ASC) as the only source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP, with the exception of Statements of Financial Accounting Standards not yet included in the Codification.
 
ASU 2009-16 (ASC 860, Transfers and Servicing). This statement eliminates the exceptions for qualifying special purpose entities (QSPE) from the consolidation guidance (ASC 810) and clarifies that the objective of the standard is to determine whether a transferor and all of the entities included in the transferor’s financial statements being presented have surrendered control over transferred financial assets. That determination must consider the transferor’s continuing involvements in the transferred financial asset including all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer. This statement modifies the financial-components approach currently used and limits the circumstances in which a financial asset, or portion of a financial asset, should be derecognized when the transferor has not transferred the entire original financial asset to an entity that is not consolidated with the transferor in the financial statements being presented and/or when the transferor has continuing involvement with the transferred financial asset.
 
 
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This statement defines the term participating interest to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale. If the transfer does not meet those conditions, a transferor should account for the transfer as a sale only if it transfers an entire financial asset or a group of entire financial assets and surrenders control over the entire transferred asset(s). This statement requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. Enhanced disclosures are required to provide financial statement users with greater transparency about transfers of financial assets and a transferor’s continuing involvement with transferred financial assets.
 
The provisions for guaranteed mortgage securitizations are removed to require those securitizations to be treated the same as any other transfer of financial assets within the scope of the standard. If such a transfer does not meet the requirements for sale accounting, the securitized mortgage loans should continue to be classified as loans in the transferor’s statement of financial position.
 
We adopted this standard effective January 1, 2010 as a result of which, we reevaluated certain QSPEs with which we had ongoing relationships as further described under ASU 2009-17, below, and reassessed the adequacy of our disclosures with regard to our servicing assets and servicing liabilities.
 
ASU 2009-17 (ASC 810, Consolidation). This standard requires an enterprise to perform ongoing periodic assessments to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. We adopted this standard effective January 1, 2010. This analysis identifies the primary beneficiary of a VIE as the enterprise that has both of the following characteristics:
 
 
(a)
The power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance
     
 
(b)
The obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE.
 
In addition to reintroducing the concept of control into the determination of the primary beneficiary of a VIE, this statement makes numerous other amendments to the current standards primarily to reflect the elimination of the concept of a QSPE under ASC 860 (above). This statement also amends the current standards to require enhanced disclosures that will provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. The enhanced disclosures are required for any enterprise that holds a variable interest in a VIE. The additional disclosures required by this statement are included in Note 1—Summary of Significant Accounting Policies.
 
As also disclosed in Note 1—Securitizations of Residential Mortgage Loans, we previously excluded certain loan securitization trusts from our consolidated financial statements because each was a QSPE. Effective January 1, 2010, we reevaluated these QSPEs as well as all other potentially significant interests in other unconsolidated entities to determine if we should include them in our consolidated financial statements.
 
ASU No. 2010-06 (ASC 820, Fair Value Measurements and Disclosures) . ASU 2010-06 revises two disclosure requirements concerning fair value measurements and clarifies two others. It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It will also require the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. These new disclosure requirements became effective for our financial statements for the period ended June 30, 2010, except for the requirement concerning gross presentation of Level 3 activity, which will become effective for fiscal years beginning after December 15, 2010. See Note 4 for our fair value disclosures related to financial instruments.
 
ASU No. 2010-20 (ASC 310, Receivables). On July 21, 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses . This standard outlines specific disclosures required for the allowance for credit losses and all finance receivables, as defined. A finance receivable is defined as a contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the entity’s statement of financial position. This definition includes instruments such as certain trade receivables, notes receivable and lease receivables as well as the instruments more traditionally associated with an allowance for credit loss, such as mortgage loans, auto loans, credit card loans and other consumer or commercial lending agreements.
 
 
13

 
 
A significant change from the current disclosure requirements will be to provide information for both the finance receivables and the related allowance for credit losses at disaggregated levels. The standard introduces two new defined terms that will govern the level of disaggregation. These include a “portfolio segment” and a “class” of financing receivable. A portfolio segment is defined as the level at which an entity determines its allowance for credit losses. For example, this may be by type of receivable, industry or risk. A class of financing receivable is defined as a group of finance receivables determined on the basis of their initial measurement attribute (i.e., amortized cost or purchased credit impaired), risk characteristics, and an entity’s method for monitoring and assessing credit risk.
 
The new guidance requires an entity to provide the extensive disclosures or information for the reporting periods presented including, but not limited to:
 
 
Presented by portfolio segment: A rollforward schedule of the allowance for credit losses (with the ending allowance balance further disaggregated based on impairment methodology) together with the related ending balance of the finance receivables; and significant purchases and sales of financing receivables.
 
 
Presented by class: The credit quality of the financing receivables portfolio at the end of the reporting period; the aging of past due financing receivables at the end of the period; the nature and extent of troubled debt restructurings that occurred during the period and their impact on the allowance for credit losses; the nature and extent of troubled debt restructurings, that occurred within the last year, that have defaulted in the current reporting period, and their impact on allowance for credit losses; the nonaccrual status of financing receivables; and impaired financing receivables.
 
Disclosures of information as of the end of a reporting period will become effective for both interim and annual reporting periods ending after December 15, 2010. Specific items regarding activity that occurred prior to the issuance of the ASU, such as the allowance rollforward and modification disclosures will be required for periods beginning after December 15, 2010.
 
NOTE 3
ACQUISITION
 
On September 1, 2010, Ocwen completed the HomEq Acquisition. The sellers were Barclays Bank PLC, a corporation organized under the laws of England and Wales (Barclays), and Barclays Capital Real Estate Inc., a corporation organized under the laws of the State of Delaware (BCRE). The HomeEq Acquisition was completed in accordance with the provisions of the Asset Purchase Agreement dated May 28, 2010 among Barclays, BCRE, OLS and Ocwen. This transaction did not result in the transfer of ownership of any legal entities.
 
Ocwen acquired HomEq Servicing in order to grow its Servicing segment. With the close of the HomEq Acquisition, Ocwen boarded 134,000 residential mortgage loans with an aggregate unpaid principal balance of $22,400,000 onto its servicing platform.
 
OLS paid an initial aggregate purchase price of $1,196,747 in cash upon completion of the HomEq Acquisition. Of this amount, $852,617 was funded by notes issued by a new $1,011,000 structured servicing advance financing facility, $150,000 was paid from funds held in escrow in accordance with the terms of the new $350,000 senior secured term loan facility and $194,130 consisted of cash and funds borrowed pursuant to the senior secured term loan facility. See Note 12 and 14 for additional details regarding the terms of the notes supporting these facilities. The initial purchase price was reduced by $29,625 pursuant to an initial true-up of advances as reflected in the table below and is subject to further true-up under adjustment mechanisms and repurchase rights in limited circumstances.
 
The transaction has been accounted for using the acquisition method of accounting which requires, among other things, the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The following table summarizes the preliminary estimate of the fair values of assets acquired and liabilities assumed as part of the HomEq Acquisition:
 
Mortgage servicing rights
  $ 84,683  
Advances
    1,062,873  
Receivables
    1,423  
Premises and equipment, net
    8,008  
Checks held for escheat (1)
    (4,616 )
Accrued bonus (1)
    (3,042 )
Servicing liabilities  (1)
    (700 )
Other liabilities (1)
    (964 )
Total identifiable net assets
    1,147,665  
Goodwill
    19,457  
Total consideration
  $ 1,167,122  

(1)
Amounts are included in Other liabilities on our Consolidated Balance Sheet.
 
 
14

 
 
Consistent with our fair value policy for mortgage servicing rights disclosed in Note 4, we estimated the fair value of the mortgage servicing rights by calculating the present value of expected future cash flows utilizing assumptions that we believe are used by market participants. The valuation of premises and equipment was based on the in-use valuation premise, where the highest and best use of the assets would provide maximum value to market participants principally through its use with other assets as a group. This valuation presumes the continued operation of the HomEq platform as installed or otherwise configured for use. Advances are non-interest bearing receivables that are expected to have a short average collections period and were, therefore, valued at their face amount, consistent with Ocwen’s fair value policy for servicing advances. Other assets and liabilities that are expected to have a short life that were valued at the face value of the specific assets and liabilities purchased, including checks held for escheat, accrued bonuses and other liabilities. Goodwill is calculated as the excess of the consideration transferred over the net assets recognized and represents the expected revenue and cost synergies of the combined business. The goodwill portion of the purchase price allocation shown in the table above pertains to the Servicing segment and is subject to adjustment as the fair value of certain other components of the purchase price are adjusted. All components of the purchase price allocation are considered preliminary. We anticipate finalizing the purchase price allocations by December 31, 2010. Potential changes in advances, premises and equipment and goodwill could be significant. If certain premises and equipment acquired from HomEq are not used in the future, they may be written down to the estimated liquidation value. Ocwen is considering subleasing office space acquired as part of the HomEq Acquisition. Further changes to the opening balance of advances will result in a cash exchange between Ocwen and Barclays and, as such, should not result in any change to goodwill.
 
The acquisition of HomEq is treated as an asset acquisition for U.S. tax purposes. We expect the opening tax basis for the acquired assets and liabilities to be the fair value, which is shown in the table above. We expect the mortgage servicing rights and goodwill to be treated as intangible assets acquired in connection with the purchase of a trade or business and as such, amortized over 15 years for tax purposes.
 
The asset purchase agreement provides for a 90-day true-up process for Advances and Mortgage servicing rights under limited circumstances. Payment for advances in the amount of $3,500 was held back in an escrow account under a four-year agreement during which Ocwen can seek reimbursement for existing and future uncollectible advances on certain pooling and servicing agreements under limited circumstances. Notwithstanding this holdback amount, the agreement provides for the reimbursement of uncollectible advances under all pooling and servicing agreements under limited circumstances.
 
Additionally, the agreement provides that any severance paid by Ocwen to HomEq employees accepting employment with Ocwen in accordance with the Barclays severance plan with payments in excess of $20,440 being reimbursed by Barclays, and conversely, that Ocwen shall pay Barclays the difference if severance paid is less than $20,440. Severance payments for all HomEq Servicing employees who entered an employment agreement with Ocwen were recorded in the third quarter as steps were taken that obligated Ocwen to pay severance for all such employees. Severance expense of $20,889 is included in Compensation and benefits in our Consolidated Statements of Operations. The projected excess of $449 is included in Receivables in our Consolidated Balance Sheet and is considered part of the HomEq Acquisition purchase price.
 
In connection with the establishment of the match funded advance facility Ocwen paid Barclays a $10,110 securitization fee and funded a reserve in the initial amount of $14,342 held by the facility Indenture Trustee for the benefit of the note holders. The securitization fee along with and certain other professional fees paid in connection with the establishment of the facility will be amortized over the expected three-year life of the notes.
 
Ocwen has agreed to assist Barclays in defending against certain litigation regarding the HomEq Servicing business that Ocwen did not assume under the terms of the Asset Purchase Agreement. Ocwen has no material financial obligation for litigation related to the operations of HomEq prior to the closing.
 
Actual and Pro forma impact of the HomEq Acquisition
 
The following table presents the revenue and earnings of HomEq Servicing that is included in our Consolidated Statement of Operations from the acquisition date of September 1, 2010 through September 30, 2010:
 
Revenues
  $ 10,402  
Net loss (1)
  $ (20,443 )
 
(1)
Net loss includes one-time transaction related expenses of $33,684, including severance and other compensation of $30,345 related to HomEq employees who accepted employment with Ocwen and $2,323 of fees for professional services related to the acquisition. Income taxes were computed using a statutory rate of 37% for federal and state income taxes.
 
 
15

 
 
The following table presents supplemental pro forma information as if the HomEq Acquisition had occurred on January 1, 2010 for the three and nine months ended September 30, 2010. The comparative 2009 columns were prepared as if the HomEq Acquisition had occurred on January 1, 2009 for the three and nine months ended September 30, 2009. As a result, the nine month periods for both years include acquisition related charges, including severance paid to HomEq employees and fees for professional services related to the acquisition. The pro forma consolidated results are not indicative of what Ocwen’s consolidated net earnings would have been had Ocwen completed the HomEq Acquisition on January 1, 2010 or 2009 because of differences in servicing practices and cost structure between Ocwen and HomEq. In addition, the pro forma consolidated results do not purport to project the future results of Ocwen combined nor do they reflect the expected realization of any cost savings associated with the HomEq Acquisition.
 
Periods ended September 30, 2010
 
Three months
   
Nine months
 
   
2010
   
2009
   
2010
   
2009
 
Revenues                                                                                      
  $ 125,324     $ 141,558     $ 366,893     $ 489,430  
Net income (loss)
  $ 5,781     $ (39,633 )   $ 17,730     $ (15,783 )
 
Through September 30, 2010, we have incurred approximately $3,744 of fees for professional services related to the HomEq Acquisition which are included in Operating expenses.
 
NOTE 4
FAIR VALUE OF FINANCIAL INSTRUMENTS
 
The carrying amounts and the estimated fair values of our financial instruments are as follows at the dates indicated:
 
   
September 30, 2010
   
December 31, 2009
 
   
Carrying
Value
   
Fair
Value
   
Carrying
Value
   
Fair
Value
 
Financial assets:
                       
Trading securities:
                       
Auction rate
  $ 74,712     $ 74,712     $ 247,464     $ 247,464  
Subordinates and residuals
                3,692       3,692  
Loans held for resale
    29,352       29,352       33,197       33,197  
Loans, net – restricted for securitization investors
    69,736       66,926              
Advances
    2,345,927       2,345,927       968,529       968,529  
Receivables, net
    42,747       42,747       67,095       67,095  
Financial liabilities:
                               
Match funded liabilities
  $ 1,606,346     $ 1,611,397     $ 465,691     $ 463,716  
Lines of credit and other secured borrowings
    444,499       452,550       55,810       56,220  
Secured borrowings – owed to securitization investors
    64,564       63,963              
Investment line
                156,968       156,968  
Servicer liabilities
    2,368       2,368       38,672       38,672  
Debt securities
    82,554       76,334       95,564       84,551  
Derivative financial instruments, net
  $ (21,419 )   $ (21,419 )   $ 781     $ 781  
 
Fair value is estimated based on a hierarchy that maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity. Unobservable inputs are inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The fair value hierarchy prioritizes the inputs to valuation techniques into three broad levels whereby the highest priority is given to Level 1 inputs and the lowest to Level 3 inputs. The three broad categories are:
 
 
Level 1:
Quoted prices in active markets for identical assets or liabilities.
     
 
Level 2:
Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly for substantially the full term of the financial instrument.
     
 
Level 3:
Unobservable inputs for the asset or liability.
 
 
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Where available, we utilize quoted market prices or observable inputs rather than unobservable inputs to determine fair value. We classify assets in their entirety based on the lowest level of input that is significant to the fair value measurement.
 
The following table sets forth assets and liabilities measured at fair value categorized by input level within the fair value hierarchy:

   
Carrying value
   
Level 1
   
Level 2
   
Level 3
 
At September 30, 2010:
                       
Measured at fair value on a recurring basis:
                       
Trading securities (1):
                               
Auction rate
  $ 74,712     $     $     $ 74,712  
Subordinates and residuals (2)
                       
Derivative financial instruments, net (3)
    (21,419 )                 (21,419 )
Measured at fair value on a non-recurring basis:
                               
Loans held for resale (4)
    29,352                   29,352  
Mortgage servicing rights (5)
    523                   523  
                                 
At December 31, 2009:
                               
Measured at fair value on a recurring basis:
                               
Trading securities (1):
                               
Auction rate
  $ 247,464     $     $     $ 247,464  
Subordinates and residuals (2)
    3,692                   3,692  
Derivative financial instruments, net (3)
    781                   781  
Measured at fair value on a non-recurring basis:
                               
Loans held for resale (4)
    33,197                   33,197  
Mortgage servicing rights (5)
    613                   613  
 
(1)
Because our internal valuation model requires significant use of unobservable inputs, these securities are classified within Level 3 of the fair value hierarchy.
   
(2)
Effective January 1, 2010, we eliminated our investment in trading securities that were issued by newly consolidated securitization trusts as more fully described in Note 1—Securitizations of Residential Mortgage Loans.
   
(3)
The fair values of derivative financial instruments as of January 1, 2010 were adjusted to include $(826) related to an interest rate swap that is held by one of the newly consolidated securitization trusts. Derivative financial instruments consist of: interest rate caps that we use to protect against our exposure to rising interest rates on two of our match funded variable funding notes; interest rate swaps to protect against our exposure to rising interest rates on a third match funded facility and a match funded facility entered into in connection with the HomEq Acquisition; the interest rate swap that is held by one of the newly consolidated loan securitization trusts; and foreign exchange forward contracts to protect against changes in the value of the Indian Rupee. See Note 18 for additional information on our derivative financial instruments.
   
(4)
Loans held for resale are measured at fair value on a non-recurring basis. At September 30, 2010 and December 31, 2009, the carrying value of loans held for resale is net of a valuation allowance of $12,551 and $15,963, respectively. Current market illiquidity has reduced the availability of observable pricing data. Consequently, we classify loans within Level 3 of the fair value hierarchy.
   
(5)
The carrying value of MSRs at September 30, 2010 and December 31, 2009 is net of a valuation allowance for impairment of $2,769 and $2,954, respectively. The carrying value of the impaired stratum, net of the valuation allowance, was $523 and $613 at September 30, 2010 and December 31, 2009, respectively. The estimated fair value exceeded amortized cost for all other strata. See Note 9 for additional information on MSRs.
 
 
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The following table sets forth a reconciliation of the changes in fair value of our Level 3 assets that we measure at fair value on a recurring basis:
 
   
Fair value at beginning of period
   
Purchases, collections and settlements, net (1)
   
Total realized and unrealized gains and (losses) (2)(3)
   
Transfers in and/or out of Level 3
   
Fair value at September 30
 
                               
Three months ended September 30, 2010:
                             
Trading securities:
                             
Auction rate
  $ 78,073     $ (400 )   $ (2,961 )   $     $ 74,712  
Subordinates and residuals
    52             (52 )            
                                         
Derivative financial instruments
    (12,278 )     58       (9,199 )           (21,419 )
                                         
Three months ended September 30, 2009:
                                       
Trading securities:
                                       
Auction rate
  $ 243,285     $ (500 )   $ 7,314     $     $ 250,099  
Subordinates and residuals
    3,440             977             4,417  
                                         
Derivative financial instruments
    957             (74 )           883  
                                         
Nine months ended September 30, 2010:
                                       
Trading securities:
                                       
Auction rate
  $ 247,464     $ (168,853 )   $ (3,899 )   $     $ 74,712  
Subordinates and residuals
    59             (59 )              
                                         
Derivative financial instruments
    (45 )     134       (21,508 )           (21,419 )
                                         
Nine months ended September 30, 2009:
                                       
Trading securities:
                                       
Auction rate
  $ 239,301     $ (2,500 )   $ 13,298     $     $ 250,099  
Subordinates and residuals
    4,369             48             4,417  
                                         
Derivative financial instruments
    193             690             883  
 
(1)
Purchases, collections and settlements, net, related to trading securities exclude interest received.
   
(2)
Total gains and (losses) on auction rate securities for the third quarter include unrealized gains (losses) of $(2,976) and $7,314 on auction rate securities still held at September 30, 2010 and 2009, respectively. For the year to date periods, unrealized gains (losses) on auction rate securities still held at September 30, 2010 and 2009 were $(2,417) and $13,298, respectively. The total gains and (losses) attributable to subordinates and residuals and derivative financial instruments were comprised principally of unrealized gains (losses) on assets held at September 30, 2010 and 2009.
   
(3)
Total gains (losses) on derivatives for the three and nine months ended September 30, 2010 include unrealized losses of $8,824 and $20,556, respectively, reported in changes in Other comprehensive loss. All other unrealized gains (losses) on derivatives for the 2010 and 2009 periods are reported in Other, net. The total gains and (losses) attributable to derivative financial instruments were comprised principally of unrealized gains (losses) on assets still held at September 30, 2010 and 2009.
 
 
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The methodologies that we use and key assumptions that we make to estimate the fair value of instruments are described in more detail by instrument below:
 
Trading Securities
 
Auction Rate Securities. We estimated the fair value of the auction rate securities based on a combination of observable market inputs provided by actual orderly sales of similar auction rate securities and a discounted cash flow analysis. This discounted cash flow analysis incorporates expected future cash flows based on our best estimate of market participant assumptions. In periods of market illiquidity, the fair value of auction rate securities is determined after consideration of the credit quality of the securities held and the underlying collateral, market activity and general market conditions affecting auction rate securities.
 
The discounted cash flow analysis included the following range of assumptions at September 30, 2010:
 
·         Expected term
 
 12 - 48 months
·         Discount to face value upon liquidation
 
0.00% - 4.00%
·         Illiquidity premium
 
0.27% - 0.96%
·         Discount rate
 
1.06% - 2.51%
 
The expected term was based upon our best estimate of market participants’ expectations of future successful auctions. The discount rate and illiquidity premium are consistent with prevailing rates for similar securities. The discount to face value upon liquidation is based on observed tender offers for similar securities. Other significant assumptions that we considered in our analysis included the credit risk profiles of the issuers, the impact on the issuers of the increased debt service costs associated with the payment of penalty interest rates and the collateralization of the securitization trusts. We do not assume defaults in our valuation due to the high credit quality of both the securities we hold and the underlying collateral.
 
Subordinates and Residuals. Our subordinate and residual securities are not actively traded, and, therefore, we estimate the fair value of these securities based on the present value of expected future cash flows from the underlying mortgage pools. We use our best estimate of the key assumptions we believe are used by market participants. We calibrate our internally developed discounted cash flow models for trading activity when appropriate to do so in light of market liquidity levels. Key inputs include expected prepayment rates, delinquency and cumulative loss curves and discount rates commensurate with the risks. Where possible, we use observable inputs in the valuation of our securities. However, the subordinate and residual securities in which we invest typically trade infrequently and therefore have few or no observable inputs and little price transparency. Additionally, during periods of market dislocation, the observability of inputs is further reduced.
 
Discount rates for the subordinate and residual securities range are determined based upon an assessment of prevailing market conditions and prices for similar assets. We project the delinquency, loss and prepayment assumptions based on a comparison to actual historical performance curves adjusted for prevailing market conditions.
 
Derivative Financial Instruments
 
Exchange-traded derivative financial instruments are valued based on quoted market prices. If quoted market prices or other observable inputs are not available, fair value is based on estimates provided by third-party pricing sources.
 
Loans Held for Resale
 
Loans held for resale are reported at the lower of cost or fair value. We account for the excess of cost over fair value as a valuation allowance with changes in the valuation allowance included in Gain (loss) on loans held for resale, net, in the period in which the change occurs. All loans held for resale were measured at fair value because the cost of $41,903 exceeded the estimated fair value of $29,352 at September 30, 2010.
 
When we enter into an agreement to sell a loan to an investor at a set price, the loan is valued at the commitment price. The fair value of loans for which we do not have a firm commitment to sell is based upon a discounted cash flow analysis. We stratify our fair value estimate of uncommitted loans held for resale based upon the delinquency status of the loans. We base the fair value of our performing loans on the expected future cash flows discounted at a rate commensurate with the risk of the estimated cash flows. Significant assumptions include collateral and loan characteristics, prevailing market conditions and the creditworthiness of the borrower. The fair value of our non-performing loans is determined based upon the underlying collateral of the loan and the estimated period and cost of disposition.
 
 
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Loans – Restricted for Securitization Investors
 
Loans – restricted for securitization investors are reported at cost, less an allowance for loan losses and are comprised of loans that are secured by first or second liens on one- to four-family residential properties. We base the fair value of our loans on the expected future cash flows discounted at a rate commensurate with the risk of the estimated cash flows. Significant assumptions include expected prepayment rates and delinquency and cumulative loss curves.
 
Mortgage Servicing Rights
 
We estimate the fair value of our MSRs by calculating the present value of expected future cash flows utilizing assumptions that we believe are used by market participants. The most significant assumptions used in our internal valuation are the speed at which mortgages prepay and delinquency experience both of which we derive from our historical experience and available market data. Other assumptions used in our internal valuation are:
 
 
·
Cost of servicing
 
·
Interest rate used for computing float earnings
 
·
Discount rate
 
·
Compensating interest expense
 
·
Interest rate used for computing the cost of servicing advances
     
 
The significant components of the estimated future cash inflows for MSRs include servicing fees, late fees, prepayment penalties, float earnings and other ancillary revenues. Significant cash outflows include the cost of servicing, the cost of financing servicing advances and compensating interest payments. We derive prepayment speeds and delinquency assumptions from historical experience adjusted for prevailing market conditions. We develop the discount rate internally, and we consider external market-based assumptions in determining the interest rate for the cost of financing advances, the interest rate for float earnings and the cost of servicing. The more significant assumptions used in the September 30, 2010 valuation include prepayment speeds ranging from 14.25% to 18.09% (depending on loan type) and delinquency rates ranging from 14.4% to 33.2% (depending on loan type). Other assumptions include an interest rate of 1-month LIBOR plus 4% for computing the cost of financing advances, an interest rate of 1-month LIBOR for computing float earnings and a discount rate of 20%.
 
We perform an impairment analysis based on the difference between the carrying amount and fair value after grouping our loans into the applicable strata based on one or more of the predominant risk characteristics of the underlying loans. The risk factors used to assign loans to strata include the credit score (FICO) of the borrower, the loan to value ratio and the default risk. Our strata include:
 
 
·
Subprime
 
·
Re-performing
 
·
ALT A
 
·
Special servicing
 
·
High-loan-to-value
 
·
Other
 
Advances
 
We value advances that we make on loans that we service for others at their carrying amounts because they have no stated maturity, generally are realized within a relatively short period of time and do not bear interest.
 
Receivables
 
The carrying value of receivables generally approximates fair value because of the relatively short period of time between their origination and realization.
 
Borrowings
 
Borrowings not subject to a hedging relationship are carried at amortized cost. We base the fair value of our debt securities on quoted market prices. The carrying value of match funded liabilities and secured borrowings that bear interest at a rate that is adjusted regularly based on a market index approximates fair value. For other match funded or secured borrowings that bear interest at a fixed rate, we determine fair value by discounting the contractual future principal and interest repayments at a market rate commensurate with the risk of the estimated cash flows. We carry certain zero-coupon long-term secured borrowings with an implicit fixed rate at a discounted value and determine fair value by discounting the contractual future principal repayments at a market rate that is commensurate with the risk of the estimated cash flows.
 
Servicer Liabilities
 
The carrying value of servicer liabilities approximates fair value due to the short period of time the funds are held until they are deposited in collection accounts, paid directly to an investment trust or refunded to borrowers.
 
 
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NOTE 5
TRADING SECURITIES
 
Trading securities consisted of the following at the dates indicated:
 
   
September 30, 2010
   
December 31, 2009
 
             
Auction rate (Corporate Items and Other)
  $ 74,712     $ 247,464  
                 
Subordinates and residuals:
               
Loans and Residuals (1)
  $     $ 3,634  
Corporate Items and Other
          58  
    $     $ 3,692  
 
Gain (loss) on trading securities for the periods ended September 30, was comprised of the following:
 
   
Three months
   
Nine months
 
   
2010
   
2009
   
2010
   
2009
 
Unrealized gains (losses):
                       
Auction rate securities
  $ (2,976 )   $ 7,314     $ (2,007 )   $ 13,298  
Subordinates and residuals (1)
    (52 )     977       (59 )     48  
    $ (3,028 )   $ 8,291     $ (2,066 )   $ 13,346  
Realized gains (losses) – Auction rate securities
    15             (1,892 )      
    $ (3,013 )   $ 8,291     $ (3,958 )   $ 13,346  
 
(1)
Effective January 1, 2010, we eliminated our investment in trading securities that were issued by newly consolidated securitization trusts as more fully described in Note 1—Securitizations of Residential Mortgage Loans, as well as the related unrealized gains and losses.
 
Auction Rate Securities
 
During the first quarter of 2008, we invested investment line borrowings (see Note 15) in auction rate securities backed by student loans originated under the U. S. Department of Education’s Federal Family Education Loan Program (FFELP). Auction rate securities are long-term variable rate bonds tied to short-term interest rates that reset through an auction process that historically occurred every 7 to 35 days. The student loans underlying the auction rate securities carry a U.S Government guarantee of at least 97% of the unpaid principal balance in the event of default. The auction rate securities that we hold are in the senior-most position and are smaller in amount than the federally guaranteed portion of the underlying loans.
 
On January 21, 2010 and March 4, 2010, we negotiated settlements of two of our auction rate securities litigation actions. Under the terms of these settlements, the broker/dealers repurchased $103,625 par value of auction rate securities for cash proceeds of $92,745. On February 10, 2010, we sold auction rate securities with a par value of $33,350 for cash proceeds of $29,848.
 
Under the terms of the liquidity option agreement we entered into in October 2009, we have the right to sell specific securities for cash. We also have the right to repurchase the same following the initial sale at the same price. On February 11, 2010, we exercised a portion of our option to sell auction rate securities with a par value of $88,150 and received proceeds of $74,953. We recognized the sale as a secured borrowing because of our ability to repurchase the same securities until the maturity of the liquidity option in October 2012. On June 24, 2010, we repurchased $46,800 par value of these securities at the initial sale price of $40,504 and sold them for cash proceeds of $44,460. We continue to report on our Consolidated Balance Sheet the remaining $41,350 par value of these auction rate securities, with a fair value of $39,607 as of September 30, 2010. However, these securities are pledged to collateralize a $34,449 borrowing reflecting the proceeds received upon exercise of the option. We no longer receive cash interest income on the pledged securities nor do we pay cash interest on this secured borrowing. See Note 14 for additional information on this secured borrowing.
 
We used proceeds from the January 21, 2010 litigation settlement and the February 10, 2010 sale to pay down the investment line. On February 17, 2010, we used the proceeds from the February 11, 2010 exercise of the liquidity option and an additional $3,664 cash to repay the remaining balance of the investment line.
 
In June 2010, we sold auction rate securities with a par value of $35,000 under an agreement to repurchase and received proceeds of $21,704. We report repurchase agreements as collateralized financings and report the obligations to repurchase the assets sold as a liability on our Consolidated Balance Sheet. See Note 14 for additional details regarding the terms of the financing obligation. We report the auction rate securities underlying the repurchase agreement, which had a fair value of $33,118 at September 30, 2010, in our Consolidated Balance Sheet.
 
 
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The remaining $2,000 par value of auction rate securities are not financed.
 
During the nine months ended September 30, 2010, issuers redeemed, at par, auction rate securities we held that had a face value of $1,800.
 
Subordinates and Residuals
 
Through our investment in subordinate and residual securities, we support senior classes of securities. Principal from the underlying mortgage loans generally is allocated first to the senior classes with the most senior class having a priority right to the cash flow from the mortgage loans until its payment requirements are satisfied. To the extent that there are defaults and unrecoverable losses on the underlying mortgage loans, resulting in reduced cash flows, the most subordinate security will be the first to bear this loss.
 
NOTE 6
ADVANCES
 
Advances consisted of the following at the dates indicated:
 
   
September 30, 2010
   
December 31, 2009
 
Servicing:
           
Principal and interest
  $ 104,926     $ 51,598  
Taxes and insurance
    53,183       52,813  
Foreclosure and bankruptcy costs
    28,275       28,021  
Other
    28,405       8,998  
      214,789       141,430  
Loans and Residuals
    3,988       4,321  
Corporate Items and Other
    159       163  
    $ 218,936     $ 145,914  
 
During any period in which the borrower does not make payments, most of our servicing agreements require that we advance our own funds to meet contractual principal and interest remittance requirements for the investors, pay property taxes and insurance premiums and process foreclosures. We also advance funds to maintain, repair and market foreclosed real estate properties on behalf of investors.
 
Servicing advances of $79,936 and $72,670 were pledged as collateral under the terms of the term reimbursement advance borrowing as of September 30, 2010 and December 31, 2009, respectively.
 
NOTE 7
MATCH FUNDED ADVANCES
 
Match funded advances on residential loans we service for others, as more fully described in Note 1—Principles of Consolidation-Match Funded Advances on Loans Serviced for Others, are comprised of the following at the dates indicated:
 
   
September 30, 2010