Discover 2014 Annual Report Download - page 161

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• Forward delivery contracts. Under the Company's risk management policy, the Company economically
hedges the changes in fair value of IRLCs and mortgage loans held for sale caused by changes in interest
rates by using TBA MBS and entering into best-efforts forward delivery contracts. These hedging instruments
are recorded at fair value with changes in fair value recorded in other income. TBA MBS used to hedge both
IRLCs and loans held for sale are valued based primarily on observable inputs related to characteristics of the
underlying MBS stratified by product, coupon and settlement date. Therefore, these derivatives are classified
as Level 2. Best-efforts forward delivery contracts are valued based on investor pricing tables, which are
observable inputs, stratified by product, note rate, and term, adjusted for current market conditions. An
anticipated loan funding probability is applied to value best-efforts contracts hedging IRLCs, which results in
the classification of these contracts as Level 3. The current base loan price and, for best-efforts contracts
hedging IRLCs, the anticipated loan funding probability, are the most significant assumptions affecting the
value of the best-efforts contracts. The best-efforts forward delivery contracts hedging loans held for sale are
classified as Level 2, so such contracts are transferred from Level 3 to Level 2 at the time the underlying loan
is originated. For the purposes of the tables below, the Company refers to TBA MBS and best-efforts forward
delivery contracts as forward delivery contracts.
Other Derivative Financial Instruments
The Company's other derivative financial instruments consist of interest rate swaps and foreign exchange forward
contracts. These instruments are classified as Level 2 as their fair values are estimated using proprietary pricing models,
containing certain assumptions based on readily observable market-based inputs, including interest rate curves, option
volatility and foreign currency forward and spot rates. In determining fair values, the pricing models use widely
accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative.
This analysis reflects the contractual terms of the derivatives, including the period to maturity and the observable market-
based inputs. The fair values of the interest rate swaps are determined using the market standard methodology of
netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or
receipts). The variable cash payments are based on an expectation of future interest rates derived from the observable
market interest rate curves. The Company considers collateral and master netting agreements that mitigate credit
exposure to counterparties in determining the counterparty credit risk valuation adjustment. The fair values of the
currency instruments are valued comparing the contracted forward exchange rate pertaining to the specific contract
maturities to the current market exchange rate.
The Company validates the fair value estimates of interest rate swaps primarily through comparison to the fair
value estimates computed by the counterparties to each of the derivative transactions. 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 performs due diligence in understanding the impact to any changes to the valuation
techniques performed by proprietary pricing models prior to implementation, working closely with the third-party
valuation service, and reviews the control objectives of the service at least annually. The Company corroborates the fair
value of foreign exchange forward contracts through independent calculation of the fair value estimates.
Assets and Liabilities under the Fair Value Option
The Company has elected to account for mortgage loans held for sale at fair value. Electing the fair value option
allows a better offset of the changes in fair values of the loans and the forward delivery contracts used to economically
hedge them without the burden of complying with the requirements for hedge accounting. At December 31, 2014 and
2013, the aggregate unpaid principal balance of loans held for sale for which the fair value option had been elected
was $117 million and $146 million, respectively. At December 31, 2014 and 2013, the same loans had a fair value of
$122 million and $148 million, respectively. For the years ended December 31, 2014 and 2013, $18 million, and $37
million of losses, respectively, from fair value adjustments on mortgage loans held for sale were recorded in other
revenue on the consolidated statements of income.