Discover 2014 Annual Report Download - page 160

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There were no transfers between Levels 1 and 2 within the fair value hierarchy for the years ended December 31,
2014 and 2013.
Available-for-Sale Investment Securities
Investment securities classified as available-for-sale consist of U.S. Treasury and government agency securities,
residential mortgage-backed securities, and credit card asset-backed securities issued by other financial institutions. The
fair value estimates of investment securities classified as Level 1, consisting of U.S. Treasury and government agency
securities, are determined based on quoted market prices for the same or similar securities. The Company classifies all
other available-for-sale investment securities as Level 2, the fair value estimates of which are primarily obtained from
pricing services, where fair values are estimated using pricing models based on observable market inputs or recent
trades of similar securities. The fair value estimates of mortgage-backed and credit card asset-backed securities are
based on the best information available. This data may consist of observed market prices, broker quotes or discounted
cash flow models that incorporate assumptions such as benchmark yields, issuer spreads, prepayment speeds, credit
ratings and losses, the priority of which may vary based on availability of information.
The Company validates the fair value estimates provided by the pricing services primarily by comparison to
valuations obtained through other pricing sources. The Company evaluates pricing variances amongst different pricing
sources to ensure that the valuations utilized are reasonable. The Company also corroborates the reasonableness of the
fair value estimates with analysis of trends of significant inputs, such as market interest rate curves. The Company
further performs due diligence in understanding the procedures and techniques performed by the pricing services to
derive fair value estimates.
At December 31, 2014, amounts reported in residential mortgage-backed securities reflect government-rated
obligations issued by Fannie Mae, Freddie Mac and Ginnie Mae with a par value of $1.4 billion, a weighted-average
coupon of 2.81% and a weighted-average remaining maturity of four years.
Mortgage Loans Held for Sale and Related Derivative Instruments
The Company enters into commitments with consumers to originate mortgage loans at a specified interest rate,
known as interest rate lock commitments (“IRLCs”). The Company reports IRLCs as derivative instruments at fair value
with changes in fair value being recorded in other income. IRLCs and mortgage loans held for sale under certain loan
programs are hedged in aggregate using “to be announced mortgage-backed securities” (“TBA MBS”). IRLCs and
mortgage loans held for sale under loan programs that generally have lower volume are hedged on an individual loan
level using best-efforts forward delivery contracts.
Fair values for each of these instruments are determined using quantitative risk models. The Company has various
monitoring processes in place to validate these valuations, including valuations of Level 3 assets. Valuation results are
reviewed in comparison to expected results, recent activity and historical trends. Any significant or unusual fluctuations
in value are analyzed.
• Mortgage loans held for sale. Valuations of mortgage loans held for sale are based on the loan amount,
note rate, loan program, expected sale date of the loan and, most significantly, investor pricing tables
stratified by product, note rate and term, adjusted for current market conditions. Mortgage loans held for
sale are classified as Level 2 as the investor pricing tables used to value them are an observable input.
Impaired mortgage loans held for sale are classified as Level 3 as loss severity is an unobservable input used
in valuation. The Company recognizes interest income separately from changes in fair value.
• Interest rate lock commitments. IRLCs for loans to be sold to investors using a mandatory or assignment of
trade method derive their base value from an underlying loan type with similar characteristics using the TBA
MBS market, which is actively quoted and easily validated through external sources. The data inputs used in
this valuation include, but are not limited to, loan type, underlying loan amount, note rate, loan program,
and commitment term. IRLCs for loans to be sold to investors on a best-efforts basis derive their base value
from the value of the underlying loans using investor pricing tables stratified by product, note rate and term,
adjusted for current market conditions. These valuations are adjusted at the loan level to consider the
servicing release premium and loan pricing adjustments specific to each loan. For all IRLCs, this base value is
then adjusted for the anticipated loan funding probability, or pull through rate. The anticipated loan funding
probability is an unobservable input based on historical experience, which results in classification of IRLCs as
Level 3.