ONITY GROUP INC.ONIT
ONITY GROUP INC. Fair Value Disclosure
Note 3 — Fair Value
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 that 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.
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.
Level 3: Unobservable inputs for the asset or liability.
We classify assets and liabilities in their entirety based on the lowest level of input that is significant to the fair value measurement.
The carrying amounts and the estimated fair values of our financial instruments and certain of our nonfinancial assets measured at fair value on a recurring or non-recurring basis or disclosed, but not measured, at fair value are as follows:
| December 31, | |||||||||||||||||||||||||||||
| 2025 | 2024 | ||||||||||||||||||||||||||||
| Level | Carrying Value | Fair Value | Carrying Value | Fair Value | |||||||||||||||||||||||||
| Financial assets: | |||||||||||||||||||||||||||||
Advances, net (b) | 3 | $ | 483.4 | $ | 483.4 | $ | 577.2 | $ | 577.2 | ||||||||||||||||||||
Loans held for sale, at fair value (a) (d) | 3, 2 | $ | 1,891.7 | $ | 1,891.7 | $ | 1,290.2 | $ | 1,290.2 | ||||||||||||||||||||
Reverse loans held for sale pooled into HMBS, at fair value (a) | 3 | $ | 9,807.5 | $ | 9,807.5 | $ | — | $ | — | ||||||||||||||||||||
Loans held for investment, at fair value (a) | 3 | $ | — | $ | — | $ | 11,125.3 | $ | 11,125.3 | ||||||||||||||||||||
Receivables, net (b) | 3 | $ | 189.8 | $ | 189.8 | $ | 176.4 | $ | 176.4 | ||||||||||||||||||||
| Financial liabilities: | |||||||||||||||||||||||||||||
HMBS-related borrowings, at fair value (a) | 3 | $ | 9,611.7 | $ | 9,611.7 | $ | 10,872.1 | $ | 10,872.1 | ||||||||||||||||||||
MSR related financing liabilities, at fair value (a) | 3 | $ | 842.0 | $ | 842.0 | $ | 846.9 | $ | 846.9 | ||||||||||||||||||||
MSR financing facilities (b) (c) | 3 | $ | 1,285.2 | $ | 1,278.3 | $ | 957.9 | $ | 947.6 | ||||||||||||||||||||
Advance match funded liabilities (b) | 3 | $ | 341.9 | $ | 341.9 | $ | 417.1 | $ | 417.1 | ||||||||||||||||||||
Mortgage warehouse facilities (b) | 3 | $ | 1,224.6 | $ | 1,224.6 | $ | 1,046.3 | $ | 1,046.3 | ||||||||||||||||||||
Reverse mortgage securitization notes (b) (c) | 3 | $ | 899.3 | $ | 909.6 | $ | 481.9 | $ | 488.9 | ||||||||||||||||||||
Senior notes (b) (c) | 3, 2 | $ | 489.6 | $ | 515.0 | $ | 487.4 | $ | 495.0 | ||||||||||||||||||||
| Derivative financial instrument assets (liabilities), net | |||||||||||||||||||||||||||||
Interest rate lock commitments (IRLCs) (a) | 3 | $ | 17.3 | $ | 17.3 | $ | (0.5) | $ | (0.5) | ||||||||||||||||||||
Other derivatives (a) | 1 | 1.7 | 1.7 | (11.7) | (11.7) | ||||||||||||||||||||||||
MSRs (a) | 3 | $ | 2,825.3 | $ | 2,825.3 | $ | 2,466.3 | $ | 2,466.3 | ||||||||||||||||||||
(a)Measured at fair value on a recurring basis in our financial statements.
(b)Disclosed, but not measured at fair value in our financial statements.
(c)The carrying values are net of unamortized debt issuance costs and discount. See Note 14 — Borrowings for additional information.
(d)The newly originated portfolio of loans held for sale pending securitization with the Agencies or sale is classified as Level 2; all other loans are classified as Level 3.
The following tables present a reconciliation of the changes in fair value of certain Level 3 assets and liabilities that we measure at fair value on a recurring basis (refer to the respective notes for other Level 3 assets and liabilities):
Years Ended December 31, | |||||||||||||||||||||||||||||||||||
| 2025 | 2024 | 2023 | |||||||||||||||||||||||||||||||||
| Loans Held for Sale - Fair Value | IRLCs | Loans Held for Sale - Fair Value | IRLCs | Loans Held for Sale - Fair Value | IRLCs | ||||||||||||||||||||||||||||||
| Beginning balance | $ | 472.9 | $ | (0.5) | $ | 203.1 | $ | 5.6 | $ | 32.1 | $ | (0.7) | |||||||||||||||||||||||
| Purchases, issuances, sales and settlements | |||||||||||||||||||||||||||||||||||
Purchases and other | 872.5 | — | 550.9 | — | 364.2 | — | |||||||||||||||||||||||||||||
Issuances (1) | — | 226.4 | — | 28.9 | — | 39.3 | |||||||||||||||||||||||||||||
| Sales | (316.9) | — | (170.8) | — | (102.4) | — | |||||||||||||||||||||||||||||
| Settlements | (172.3) | — | (92.2) | — | (60.5) | — | |||||||||||||||||||||||||||||
Transfers from (to): | |||||||||||||||||||||||||||||||||||
Loans held for sale, at fair value (1) | — | (159.9) | — | (26.0) | — | (64.9) | |||||||||||||||||||||||||||||
Reverse mortgage loans, at fair value | 13.1 | — | 4.8 | — | 4.5 | — | |||||||||||||||||||||||||||||
| Receivables, net | (70.5) | — | (32.9) | — | (34.7) | — | |||||||||||||||||||||||||||||
REO (Other assets) | (61.9) | — | (26.8) | (15.2) | — | ||||||||||||||||||||||||||||||
Advances (incl. capitalization upon Ginnie Mae modification) | 17.3 | — | 9.4 | — | 4.4 | — | |||||||||||||||||||||||||||||
Other | (6.8) | — | 2.9 | — | (0.9) | — | |||||||||||||||||||||||||||||
Net additions (disposition/derecognition) | 274.5 | 66.5 | 245.3 | 3.0 | 159.3 | (25.6) | |||||||||||||||||||||||||||||
Included in earnings: | |||||||||||||||||||||||||||||||||||
Change in fair value (1) | 32.7 | (48.7) | 24.5 | (9.1) | 11.7 | 32.0 | |||||||||||||||||||||||||||||
| Ending balance | $ | 780.1 | $ | 17.3 | $ | 472.9 | $ | (0.5) | $ | 203.1 | $ | 5.6 | |||||||||||||||||||||||
(1)IRLC activity (issuances and transfers) represent changes in fair value included in earnings. This activity is presented on a gross basis in the table for disclosure purposes. Total net change in fair value included in earnings attributed to IRLCs is a gain (loss) of $17.8 million, $(6.2) million and $6.3 million for 2025, 2024 and 2023, respectively. See Note 18 — Derivative Financial Instruments and Hedging Activities. A reconciliation from the beginning balances to the ending balances of Reverse loans held for investment, held for sale pooled into HMBS and HMBS-related borrowings, MSRs and MSR related financing liabilities that we measure at fair value on a recurring basis is disclosed in Note 5 – Reverse Mortgages, Note 7 — Mortgage Servicing and Note 8 — MSR Related Financing Liabilities, at Fair Value, respectively.
The methodologies that we use and key assumptions that we make to estimate the fair value of financial instruments and other assets and liabilities measured at fair value on a recurring or non-recurring basis and those disclosed, but not carried, at fair value are described below.
Loans Held for Sale
Residential forward and reverse mortgage loans held for sale are carried at fair value and are generally classified within Level 2 of the valuation hierarchy. The primary component of the price is obtained from observable values of mortgage forwards for loans of similar terms and characteristics. We have the ability to access this market, and it is the market into which conventional and government-insured mortgage loans are typically sold.
Repurchased Ginnie Mae forward and reverse loans are classified as Level 3 within the valuation hierarchy. We repurchase certain loans from Ginnie Mae guaranteed securitizations in connection with loan modifications, strategic EBO and loan resolution activity as part of our contractual obligations as the servicer of the loans. The fair value of the forward mortgage loans we purchased from Ginnie Mae guaranteed securitizations is estimated using both observable and unobservable inputs, including estimated default, prepayment, and discount rates. Significant unobservable inputs in estimating fair value include the estimated default rate and, for reverse loans the prepayment rate and liquidation timeline.
Loans Held for Investment and Reverse loans Held for Sale pooled into HMBS - Reverse Mortgages
Reverse mortgage loans classified as loans held for investment through November 2025 and Reverse loans held for sale pooled into HMBS thereafter are carried at fair value and classified as Level 3 within the valuation hierarchy. These loans are not actively traded, and quoted market prices are not available. We measure these loans at fair value based on the expected future cash flows discounted over the expected life of the loans at a rate commensurate with the risk of the estimated cash flows, including future draw commitments for HECM loans. Inputs of the discounted cash flows of these assets include future draws and tail securitization spreads, conditional prepayment rate (including voluntary and involuntary prepayments) and discount rate.
We engage third-party valuation experts in the determination of fair value. While the models and related assumptions used by the valuation experts are proprietary to them, we understand the methodologies, the significant inputs and the assumptions used to develop the prices based on our ongoing due diligence, which includes regular discussions with the valuation experts. We evaluate the reasonableness of our third-party experts’ assumptions using historical experience, or cash flow backtesting, adjusted for prevailing market conditions and benchmarks of assumptions and value estimates. The fair value is equal to the third-party valuation expert fair value mark.
Significant unobservable assumptions include conditional prepayment rate and discount rate. The conditional prepayment rate assumption displayed in the table below is inclusive of voluntary (repayment or payoff) and involuntary (inactive/delinquent status and default) prepayments. The discount rate assumption is primarily based on an assessment of current market yields on reverse mortgage loan and tail securitizations, expected duration of the asset and current market interest rates.
| December 31, | |||||||||||
| Significant unobservable assumptions | 2025 | 2024 | |||||||||
| Life in years | |||||||||||
| Range | 0.6 to 7.8 | 0.4 to 7.6 | |||||||||
| Weighted average | 4.7 | 4.2 | |||||||||
Conditional prepayment rate (CPR), including voluntary and involuntary prepayments (a) | |||||||||||
| Range | 13.1% to 26.6% | 13.1% to 31.6% | |||||||||
| Weighted average | 18.9 | % | 21.3 | % | |||||||
| Discount rate | 4.8 | % | 5.4 | % | |||||||
(a)Annualized rate of lifetime projected prepayments as a percentage of the UPB at the beginning of any given period.
Significant changes in any of these assumptions in isolation could result in a significant change in fair value. The effects of changes in the assumptions used to value the securitized loans held for investment, excluding future draw commitments, are partially offset by the effects of changes in the assumptions used to value the HMBS-related borrowings that are associated with these loans.
MSRs
MSRs are carried at fair value and classified within Level 3 of the valuation hierarchy. MSRs are not actively traded, and quoted market prices are not available. We determine the fair value of MSRs primarily using discounted cash flow methodologies. The significant components of the estimated future cash inflows for MSRs include servicing fees, late fees, float earnings and other ancillary fees. Significant cash outflows include the cost of servicing, the cost of financing servicing advances and compensating interest payments.
We engage third-party valuation experts who generally utilize: (a) transactions involving instruments with similar collateral and risk profiles, adjusted as necessary based on specific characteristics of the asset or liability being valued; and/or (b) industry-standard modeling, such as a discounted cash flow model and prepayment model, in arriving at their estimate of fair value. The prices provided by the valuation experts reflect their observations and assumptions related to market activity, generally the bulk market, incorporating available industry survey results and client feedback, and including risk premiums and liquidity adjustments. While interest rates are a key value driver, MSR fair value may change for other market-driven factors, including but not limited to the supply and demand of the market or the required yield or perceived value by investors of such MSRs. While the models and related assumptions used by the valuation experts are proprietary to them, we understand the methodologies and assumptions used to develop the prices based on our ongoing due diligence, which includes regular discussions with the valuation experts. We evaluate the reasonableness of our third-party experts’ assumptions using historical experience adjusted for prevailing market conditions and benchmarks of assumptions and value estimates. We believe that the procedures executed by the valuation experts, supported by our verification and analytical procedures, provide reasonable assurance that the prices used in our consolidated financial statements comply with the accounting guidance for fair value measurements and disclosures and reflect the assumptions that a market participant would use.
Assumptions used in the valuation of MSRs include:
| • | Mortgage prepayment speeds | • | Delinquency rates | ||||||||
| • | Cost of servicing | • | Interest rate used for computing float earnings | ||||||||
| • | Discount rate | • | Compensating interest expense | ||||||||
| • | Interest rate used for computing the cost of financing servicing advances | • | Collection rate of other ancillary fees | ||||||||
| • | Curtailment on advances | ||||||||||
The fair value is equal to the fair value mark provided by the third-party valuation experts, without adjustment, except in the event we have a potential or completed sale, including transactions where we have executed letters of intent, in which case the fair value of the MSRs is recorded at the estimated sale price.
A change in the valuation inputs or assumptions may result in a significantly higher or lower fair value measurement. Changes in market interest rates predominantly impact the fair value of Agency MSRs via prepayment speeds by altering the borrower refinance incentive and the non-Agency MSRs due to the impact on advance funding costs. In addition, changes in market interest rates impact float income. The significant unobservable assumptions used in the valuation of these MSRs include discount rate, prepayment speed, delinquency rates, and cost to service.
Significant Unobservable Assumptions | December 31, | ||||||||||||||||||||||||||||||||||
| 2025 | 2024 | ||||||||||||||||||||||||||||||||||
GSE | Ginnie Mae | Non-Agency | GSE | Ginnie Mae | Non-Agency | ||||||||||||||||||||||||||||||
| Discount rate | |||||||||||||||||||||||||||||||||||
| Range | 8.9% to 15.1% | 10.5% to 15.0% | 9.5% to 14.5% | 7.9% to 16.0% | 10.8% to 15.3% | 9.5% to 14.5% | |||||||||||||||||||||||||||||
Weighted average | 9.2 | % | 10.6 | % | 10.4 | % | 9.8 | % | 10.8 | % | 10.9 | % | |||||||||||||||||||||||
| Prepayment speed | |||||||||||||||||||||||||||||||||||
| Range | 4.0% to 10.0% | 5.7% to 10.6% | 5.4% to 7.5% | 3.7% to 8.8% | 5.6% to 12.5% | 5.7% to 8.7% | |||||||||||||||||||||||||||||
Weighted average | 6.8 | % | 7.7 | % | 6.4 | % | 6.2 | % | 7.6 | % | 7.8 | % | |||||||||||||||||||||||
| Delinquency | |||||||||||||||||||||||||||||||||||
| Range | 0.4% to 1.0% | 4.8% to 9.1% | 9.0% to 17.7% | 0.4% to 1.2% | 5.2% to 10.7% | 8.0% to 18.3% | |||||||||||||||||||||||||||||
Weighted average | 0.5 | % | 5.6 | % | 12.0 | % | 0.5 | % | 6.0 | % | 10.4 | % | |||||||||||||||||||||||
| Cost to service (in dollars) | |||||||||||||||||||||||||||||||||||
| Range | $67 to $69 | $92 to $108 | $158 to $189 | $67 to $70 | $93 to $117 | $177 to $226 | |||||||||||||||||||||||||||||
Weighted average | $ | 67 | $ | 96 | $ | 173 | $ | 67 | $ | 98 | $ | 193 | |||||||||||||||||||||||
Because the mortgages underlying these MSRs permit the borrowers to prepay the loans, the value of the MSRs generally tends to diminish in periods of declining interest rates, an improving housing market or expanded product availability (as prepayments increase) and increase in periods of rising interest rates, a deteriorating housing market or reduced product availability (as prepayments decrease).
The following table summarizes the estimated change in the value of the MSRs as of December 31, 2025 given hypothetical increases in significant unobservable assumptions:
| Adverse change in fair value | 10% | 20% | |||||||||
| Change in weighted average discount rate (in percentage points) | 1.0 | 1.9 | |||||||||
Change in fair value due to change in weighted average discount rate | $ | (98.1) | $ | (188.4) | |||||||
| Change in weighted average prepayment speeds (in percentage points) | 0.8 | 1.6 | |||||||||
| Change in fair value due to change in weighted average prepayment speeds | $ | (77.8) | $ | (147.6) | |||||||
Change in weighted average delinquency (in percentage points) | 0.4 | 0.8 | |||||||||
Change in fair value due to change in weighted average delinquency | $ | (18.4) | $ | (33.3) | |||||||
Change in weighted average cost to service (in dollars) | 8.2 | 16.4 | |||||||||
Change in fair value due to change in weighted average cost to service (in dollars) | $ | (19.7) | $ | (39.5) | |||||||
Advances
We value advances at their net realizable value, which generally approximates fair value. Servicing advances have no stated maturity and do not bear interest. Principal and interest advances are generally realized within a relatively short period of time. The timing of recovery of taxes, insurance and other corporate advances depends on the underlying loan attributes, performance, and in many cases, foreclosure or liquidation timeline. The fair value adjustment to servicing advances associated with the estimated time to recover such advances is separately measured and reported as a component of the fair value of the associated MSR, consistent with actual market transactions. Refer to MSRs above for a description of the valuation methodology and assumptions related to the cost of financing servicing advances and discount rate, among other factors.
Receivables
The carrying value of receivables generally approximates fair value because of the relatively short period of time between their origination and realization.
Advance Match Funded Liabilities
For advance match funded liabilities that bear interest at a rate that is adjusted regularly based on a market index, the carrying value approximates fair value. We assume the notes are refinanced at the end of their revolving periods, consistent with how we manage our advance facilities.
Financing Liabilities
HMBS-Related Borrowings
HMBS-related borrowings are carried at fair value and classified as Level 3 within the valuation hierarchy. These borrowings are not actively traded, and therefore, quoted market prices are not available. We determine fair value using a discounted cash flow approach, by discounting the projected recovery of principal and interest over the estimated life of the borrowing at a market rate commensurate with the risk of the estimated cash flows.
We engage third-party valuation experts to support our valuation and provide observations and assumptions related to market activities. The fair value is equal to the fair value mark provided by a third-party valuation expert. We evaluate the reasonableness of our fair value estimate and assumptions using historical experience, or cash flow backtesting, adjusted for prevailing market conditions and benchmarks of assumptions and value estimates.
Significant unobservable assumptions include yield spread and discount rate. The yield spread and discount rate assumption for these liabilities are primarily based on an assessment of current market yields for newly issued HMBS, expected duration and current market interest rates.
| December 31, | |||||||||||
| Significant unobservable assumptions | 2025 | 2024 | |||||||||
| Life in years | |||||||||||
| Range | 0.6 to 7.8 | 0.4 to 7.6 | |||||||||
| Weighted average | 4.7 | 4.2 | |||||||||
| Conditional prepayment rate | |||||||||||
| Range | 13.1% to 26.6% | 13.1% to 31.6% | |||||||||
| Weighted average | 18.9 | % | 21.3 | % | |||||||
| Discount rate | 4.7 | % | 5.3 | % | |||||||
Significant changes in any of these assumptions in isolation could result in a significant change in fair value. The effects of changes in the assumptions used to value the HMBS-related borrowings are partially offset by the effects of changes in the assumptions used to value the associated pledged reverse loans pooled into HMBS, previously held for investment, excluding future draw commitments.
Pledged MSR Liabilities
Pledged MSR liabilities are carried at fair value and classified as Level 3 within the valuation hierarchy. We determine the fair value of the pledged MSR liability following a similar approach as for the associated transferred MSRs. Fair value of the pledged MSR liability in connection with the MSR capital partner transactions (including MAV) is determined using the fair value mark provided by third-party valuation expert, consistent with the associated MSR, using the same methodology and assumptions, while considering cash flows contractually retained by PHH and expected life of subservicing agreement, when applicable.
| December 31, | |||||||||||
| Significant unobservable assumptions | 2025 | 2024 | |||||||||
| Weighted average prepayment speed | 5.2 | % | 5.4 | % | |||||||
| Weighted average delinquency rate | 3.3 | % | 3.0 | % | |||||||
| Weighted average subservicing life (in years) | 5.2 | 4.7 | |||||||||
| Weighted average discount rate | 9.6 | % | 10.3 | % | |||||||
| Weighted average cost to service (in dollars) | $ | 124 | $ | 133 | |||||||
Significant changes in these assumptions in isolation would result in a significant change in fair value.
ESS Financing Liability
The Excess Servicing Spread (ESS) financing liability is carried at fair value and classified as Level 3 within the valuation hierarchy. The ESS financing liability consists of the obligation to remit to a third party a specified percentage of future servicing fee collections on reference pools of mortgage loans, which we are entitled to as owner of the related MSRs. The fair value represents the net present value of the expected servicing spread cash flows, consistent with the valuation model and behavioral projections of the underlying MSR, as applicable. The fair value of the ESS financing liability is determined using a third-party valuation expert. The significant unobservable assumptions used in the valuation of the ESS financing liability include prepayment speeds, delinquency rates, and discount rates. The discount rate is initially determined based on the expected cash flows and the proceeds from each issuance, and is subsequently updated, at each issuance level, to incorporate discount rate assumption updates for the underlying MSR or other factors, as provided by third-party valuation expert. At December 31, 2025 and 2024, the weighted average discount rate of the ESS financing liability was 9.8% and 10.0%, respectively. Refer to MSRs above for a description of other significant unobservable assumptions.
Mortgage Warehouse Facilities
Our mortgage warehouse facilities bear interest at a rate that is adjusted regularly based on a market index. The carrying value of the outstanding borrowings approximates fair value as short term.
Reverse Mortgage Securitization Notes
With respect to the OLIT securitization issuances, we issued senior and mezzanine classes of notes, at a discount, with fixed interest rates and mandatory call dates. We determine the fair value of these notes based on bid prices provided by third parties involved in the issuance and placement of the notes.
MSR Financing Facilities
Our MSR financing facilities bear interest at a rate that is adjusted regularly based on a market index. The carrying value of the outstanding borrowings under these facilities approximates fair value.
In 2014, we issued Ocwen Asset Servicing Income Series (OASIS), Series 2014-1 Notes secured by Ocwen-owned MSRs relating to Freddie Mac mortgages. In 2022, we issued Ocwen Excess Spread-Collateralized Notes, Series 2022-PLS1 notes secured by certain of PHH’s private label MSRs. We determine the fair value of these notes based on bid prices provided by third parties involved in the issuance and placement of the notes. At December 31, 2024, the Ocwen Excess Spread-Collateralized Notes, Series 2022-PLS1 notes carrying value approximated fair value, given their maturity in February 2025.
Senior Notes
We base the fair value on quoted prices in a market with available limited trading activity, or on valuation data obtained from a pricing service in the absence of trading data. For Senior Notes with no pricing activity or trading data, we determine the fair value by discounting future principal and interest payments at a market rate commensurate with the risk of the estimated cash flows.
Derivative Financial Instruments
Interest rate lock commitments (IRLCs) are carried at fair value and classified as Level 3 within the valuation hierarchy. IRLCs represent an agreement to purchase loans from a third-party originator or an agreement to extend credit to a mortgage applicant (locked pipeline), whereby the interest rate is set prior to funding. Fair value amounts of IRLCs are adjusted for expected “fallout” (locked pipeline loans not expected to close) using models that consider cumulative historical fallout rates and other factors. Fallout rates are determined to be significant unobservable assumptions.
We use derivative instruments, including forward trades of MBS or Agency “to be announced” securities (TBAs) and exchange-traded interest rate swap futures and options, as economic hedging instruments of the fair value of our loans held for sale and MSR portfolio. Forward contracts, TBAs and interest rate swap futures are actively traded in the market and we obtain unadjusted market quotes for these derivatives; thus, they are generally classified within Level 1 of the valuation hierarchy.
Historical Timeline
| Fiscal Year | Filed | |
|---|---|---|
| 2025 | Feb 17, 2026 | Showing above |
| 2016 | Feb 23, 2017 | |
About Fair Value Disclosures
Fair value disclosures classify all assets and liabilities measured at fair value into a three-level hierarchy: Level 1 (quoted market prices), Level 2 (observable inputs like yield curves), and Level 3 (unobservable inputs requiring management estimates). The proportion of Level 3 assets directly reflects how much of the balance sheet depends on internal models rather than market evidence.
Key signals: a growing Level 3 balance relative to total fair-value assets increases valuation uncertainty and earnings volatility risk. Watch for transfers between levels — assets moving from Level 2 to Level 3 often signal deteriorating market liquidity. Unrealized gains and losses on Level 3 positions flow through earnings or other comprehensive income, so large swings deserve scrutiny. For financial institutions, examine the sensitivity disclosures that show how Level 3 valuations change under alternative assumptions. Compare the fair value of debt against its carrying amount to gauge hidden leverage.