Drive Shack Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

FAIR VALUE OF FINANCIAL INSTRUMENTS

FAIR VALUE OF FINANCIAL INSTRUMENTS

12 Months Ended

Dec. 31, 2017

The following table summarizes the carrying values and estimated fair values of the Company’s financial instruments at December 31, 2017 and 2016:



	December 31, 2017					December 31, 2016
	Carrying Value		Estimated Fair Value		Fair Value Method (A)	Carrying Value		Estimated Fair Value
Assets
Real estate securities, available-for-sale	$	2,294	$	2,294	Pricing models	$	629,254	$	629,254
Loans, held-for-sale, net (B)	147		147		Pricing models	55,612		61,144
Residential mortgage loans, held-for-sale, net (C)	—		—		Broker/counterparty quotations, pricing models	231		249
Cash and cash equivalents	167,692		167,692			140,140		140,140
Restricted cash - current and noncurrent	5,996		5,996			6,404		6,404
Non-hedge derivative assets (D)	286		286		Counterparty quotations	856		856

Liabilities
Repurchase agreements	—		—		Counterparty quotations, market comparables	600,964		600,964
Credit facilities - Traditional Golf term loan	99,931		103,199		Pricing models	98,680		98,680
Junior subordinated notes payable	51,208		27,531		Pricing models	51,217		26,756


(A)	Pricing models are used for (i) real estate securities and loans that are not traded in an active market, and, therefore, have little or no price transparency, and for which significant unobservable inputs must be used in estimating fair value, or (ii) debt obligations which are private and untraded.


(B)	Loans held-for-sale, net are recorded in other current assets on the Consolidated Balance Sheets.


(C)	Residential mortgage loans held-for-sale, net is recorded in other current assets on the Consolidated Balance Sheets.


(D)	Represents an interest rate cap and TBA forward contracts (Note 10).

Fair Value Measurements

Valuation Hierarchy

The fair value of financial instruments is categorized based on the priority of the inputs to the valuation technique and categorized into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The Company follows this hierarchy for its financial instruments measured at fair value.

Level 1 - Quoted prices in active markets for identical instruments.

Level 2 - Valuations based principally on observable market parameters, including:

•quoted prices for similar assets or liabilities in active markets,


•	inputs other than quoted prices that are observable for the asset or liability (such as interest rates and yield curves observable at commonly quoted intervals, implied volatilities and credit spreads), and

•market corroborated inputs (derived principally from or corroborated by observable market data).

Level 3 - Valuations determined using unobservable inputs that are supported by little or no market activity, and that are significant to the overall fair value measurement.

The Company’s real estate securities and loans, and debt obligations are currently not traded in active markets and therefore have little or no price transparency. As a result, the Company has estimated the fair value of these illiquid instruments based on internal pricing models subject to the Company's controls described below.

The Company has various processes and controls in place to ensure that fair value measurements are reasonably estimated. With respect to broker and pricing service quotations, and in order to ensure these quotes represent a reasonable estimate of fair value, the Company’s quarterly procedures include a comparison of such quotations to quotations from different sources, outputs generated from its internal pricing models and transactions completed, as well as on its knowledge and experience of these markets. With respect to fair value estimates generated based on the Company’s internal pricing models, the Company’s management validates the inputs and outputs of the internal pricing models by comparing them to available independent third-party market parameters and models, where available, for reasonableness. The Company believes its valuation methods and the assumptions used are appropriate and consistent with other market participants.

Fair value measurements categorized within Level 3 are sensitive to changes in the assumptions or methodology used to determine fair value and such changes could result in a significant increase or decrease in the fair value. For the Company’s investments in real estate securities and loans categorized within Level 3 of the fair value hierarchy, the significant unobservable inputs include the discount rates, assumptions relating to prepayments, default rates and loss severities.

Recurring Fair Value Measurements - Real Estate Securities and Derivatives

The following table summarizes financial assets and liabilities measured at fair value on a recurring basis at December 31, 2017:



			Fair Value
	Carrying Value		Level 2		Level 3				Total
			Market Quotations (Observable)		Market Quotations (Unobservable)		Internal Pricing Models
Assets:
Real estate securities, available-for-sale:
ABS- Non-Agency RMBS	$	2,294	$	—	$	—	$	2,294	$	2,294

Derivative assets:
Interest rate cap, not treated as hedge	$	286	$	286	$	—	$	—	$	286

Significant Unobservable Inputs

The following table provides quantitative information regarding the significant unobservable inputs used by the Company for assets and liabilities measured at fair value on a recurring basis as of December 31, 2017.



					Weighted Average Significant Input
Asset Type	Amortized Cost Basis		Fair Value		Discount Rate		Prepayment Speed		Cumulative Default Rate		Loss Severity
ABS - Non-Agency RMBS	$	924	$	2,294	12.0	%	4.8	%	4.5	%	69.6	%
Total	$	924	$	2,294

All of the inputs used have some degree of market observability, based on the Company’s knowledge of the market, relationships with market participants, and use of common market data sources. Collateral prepayment, default and loss severity projections are in the form of “curves” or “vectors” that vary for each monthly collateral cash flow projection. Methods used to develop these projections vary by asset class but conform to industry conventions. The Company uses assumptions that generate its best estimate of future cash flows of each respective security.

The Company’s investments in instruments measured at fair value on a recurring basis using Level 3 inputs changed as follows:



	Level 3 Assets
	CMBS			ABS - Non-Agency RMBS			Equity/Other Securities			Total

Balance at December 31, 2015	$	39,684		$	9,619		$	9,731		$	59,034
CDO VI deconsolidation	(37,179		)	(6,710		)	—			(43,889		)
Total gains (losses) (A)
Included in net income (B)	(108		)	3			11,232			11,127
Included in other comprehensive income (loss)	(658		)	(1,015		)	(9,731		)	(11,404		)
Amortization included in interest income	879			278			—			1,157
Purchases, sales and settlements
Proceeds from sales	(2		)	(3		)	(11,232		)	(11,237		)
Proceeds from repayments	(2,616		)	(222		)	—			(2,838		)
Balance at December 31, 2016	$	—		$	1,950		$	—		$	1,950
Total gains (losses) (A)
Included in net income (B)	—			—			—			—
Included in other comprehensive income (loss)	—			202			—			202
Amortization included in interest income	—			196			—			196
Purchases, sales and settlements
Proceeds from repayments	—			(54		)	—			(54		)
Balance at December 31, 2017	$	—		$	2,294		$	—		$	2,294


(A)	None of the gains (losses) recorded in earnings during the periods is attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting dates. There were no purchases or sales during the year ended December 31, 2017. There were no transfers into or out of Level 3 during the years ended December 31, 2017 and 2016.


(B)	These gains (losses) are recorded in the following line items in the Consolidated Statements of Operations:



	Year Ended December 31,
	2017		2016
Realized and unrealized gain on investments	$	—	$	11,237
Impairment (reversal)	—		(110		)
Total	$	—	$	11,127
Realized and unrealized gain on investments, net, from investments transferred into Level 3 during the period	$	—	$	—

Non-Recurring Fair Value Measurements - Loans

Loans, held-for-sale are carried at the lower of amortized cost or fair value and are therefore recorded at fair value on a non-recurring basis. These loans were written down to fair value at the time of the impairment, based on internal pricing models. All the loans were within Level 3 of the fair value hierarchy. The most significant inputs used in the valuations are the amount and timing of expected future cash flows, market yields and the estimated collateral value of such loan investments.

Liabilities for Which Fair Value is Only Disclosed

The following table summarizes the level of the fair value hierarchy, valuation techniques and inputs used for estimating each class of liabilities not measured at fair value in the statement of financial position but for which fair value is disclosed:



Type of Liabilities
Not Measured At Fair
Value for Which
Fair Value Is Disclosed	Fair Value Hierarchy	Valuation Techniques and Significant Inputs

Credit facilities	Level 3	Valuation technique is based on discounted cash flows. Significant inputs include:
		•	Amount and timing of expected future cash flows
		•	Interest rates
		•	Market yields

Junior subordinated notes payable	Level 3	Valuation technique is based on discounted cash flows. Significant inputs include:
		•	Amount and timing of expected future cash flows
		•	Interest rates
		•	Market yields and the credit spread of the Company

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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