Citibank 2011 Annual Report Download - page 266

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Market valuation adjustments
Liquidity adjustments are applied to items in Level 2 and Level 3 of the
fair value hierarchy to ensure that the fair value reflects the price at which
the entire position could be liquidated in an orderly manner. The liquidity
reserve is based on the bid-offer spread for an instrument, adjusted to take
into account the size of the position consistent with what Citi believes a
market participant would consider.
Counterparty credit-risk adjustments are applied to derivatives, such
as over-the-counter derivatives, where the base valuation uses market
parameters based on the LIBOR interest rate curves. Not all counterparties
have the same credit risk as that implied by the relevant LIBOR curve, so it is
necessary to consider the market view of the credit risk of a counterparty in
order to estimate the fair value of such an item.
Bilateral or “own” credit-risk adjustments are applied to reflect the
Company’s own credit risk when valuing derivatives and liabilities measured
at fair value. Counterparty and own credit adjustments consider the expected
future cash flows between Citi and its counterparties under the terms of
the instrument and the effect of credit risk on the valuation of those cash
flows, rather than a point-in-time assessment of the current recognized net
asset or liability. Furthermore, the credit-risk adjustments take into account
the effect of credit-risk mitigants, such as pledged collateral and any legal
right of offset (to the extent such offset exists) with a counterparty through
arrangements such as netting agreements.
Auction rate securities
Auction rate securities (ARS) are long-term municipal bonds, corporate
bonds, securitizations and preferred stocks with interest rates or dividend
yields that are reset through periodic auctions. The coupon paid in the
current period is based on the rate determined by the prior auction. In the
event of an auction failure, ARS holders receive a “fail rate” coupon, which is
specified in the original issue documentation of each ARS.
Where insufficient orders to purchase all of the ARS issue to be sold
in an auction were received, the primary dealer or auction agent would
traditionally have purchased any residual unsold inventory (without a
contractual obligation to do so). This residual inventory would then be
repaid through subsequent auctions, typically in a short time. Due to this
auction mechanism and generally liquid market, ARS have historically
traded and were valued as short-term instruments.
Citigroup acted in the capacity of primary dealer for approximately
$72 billion of ARS and continued to purchase residual unsold inventory in
support of the auction mechanism until mid-February 2008. After this date,
liquidity in the ARS market deteriorated significantly, auctions failed due to
a lack of bids from third-party investors, and Citigroup ceased to purchase
unsold inventory. Following a number of ARS refinancings, at December 31,
2011, Citigroup continued to act in the capacity of primary dealer for
approximately $15 billion of outstanding ARS.
The Company classifies its ARS as trading and available-for-sale securities.
Trading ARS include primarily securitization positions and are classified as
Asset-backed securities within Trading securities in the table below. Available-
for-sale ARS include primarily preferred instruments (interests in closed-end
mutual funds) and are classified as Equity securities within Investments.
Prior to the Company’s first auction failing in the first quarter of 2008,
Citigroup valued ARS based on observation of auction market prices, because
the auctions had a short maturity period (7, 28 or 35 days). This generally
resulted in valuations at par. Once the auctions failed, ARS could no longer
be valued using observation of auction market prices. Accordingly, the fair
values of ARS are currently estimated using internally developed discounted
cash flow valuation techniques specific to the nature of the assets underlying
each ARS.
For ARS with student loans as underlying assets, future cash flows are
estimated based on the terms of the loans underlying each individual ARS,
discounted at an appropriate rate in order to estimate the current fair value.
The key assumptions that impact the ARS valuations are the expected
weighted average life of the structure, estimated fail rate coupons, the
amount of leverage in each structure and the discount rate used to calculate
the present value of projected cash flows. The discount rate used for each ARS
is based on rates observed for basic securitizations with similar maturities
to the loans underlying each ARS being valued. In order to arrive at the
appropriate discount rate, these observed rates were adjusted upward to factor
in the specifics of the ARS structure being valued, such as callability, and the
illiquidity in the ARS market.
The majority of ARS continue to be classified as Level 3.