Morgan Stanley 2010 Annual Report Download - page 152

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
others, may be deployed to model the specific collateral composition and cash flow structure of each
transaction. Key inputs to these models are market spreads, forecasted credit losses, default and
prepayment rates for each asset category. Valuation levels of RMBS and CMBS indices are also used as
an additional data point for benchmarking purposes or to price outright index positions.
RMBS, CMBS and other ABS are generally categorized in Level 2 of the fair value hierarchy. If external
prices or significant spread inputs are unobservable or if the comparability assessment involves
significant subjectivity related to property type differences, cash flows, performance and other inputs,
then RMBS, CMBS and other ABS are categorized in Level 3 of the fair value hierarchy.
• Corporate Bonds. The fair value of corporate bonds is determined using recently executed transactions,
market price quotations (where observable), bond spreads or credit default swap spreads obtained from
independent external parties such as vendors and brokers adjusted for any basis difference between cash
and derivative instruments. The spread data used are for the same maturity as the bond. If the spread data
do not reference the issuer, then data that reference a comparable issuer are used. When observable price
quotations are not available, fair value is determined based on cash flow models with yield curves, bond
or single name credit default swap spreads and recovery rates as significant inputs. Corporate bonds are
generally categorized in Level 2 of the fair value hierarchy; in instances where prices, spreads or any of
the other aforementioned key inputs are unobservable, they are categorized in Level 3 of the fair value
hierarchy.
• Collateralized Debt Obligations (“CDO”). The Company holds cash CDOs that typically reference a
tranche of an underlying synthetic portfolio of single name credit default swaps. The collateral is usually
ABS or other corporate bonds. Credit correlation, a primary input used to determine the fair value of a
cash CDO, is usually unobservable and derived using a benchmarking technique. The other model inputs
such as credit spreads, including collateral spreads, and interest rates are typically observable. CDOs are
categorized in Level 2 of the fair value hierarchy when the credit correlation input is insignificant. In
instances where the credit correlation input is deemed to be significant, these instruments are categorized
in Level 3 of the fair value hierarchy.
• Corporate Loans and Lending Commitments. The fair value of corporate loans is determined using
recently executed transactions, market price quotations (where observable), implied yields from
comparable debt, and market observable credit default swap spread levels obtained from independent
external parties such as vendors and brokers adjusted for any basis difference between cash and derivative
instruments, along with proprietary valuation models and default recovery analysis where such
transactions and quotations are unobservable. The fair value of contingent corporate lending
commitments is determined by using executed transactions on comparable loans and the anticipated
market price based on pricing indications from syndicate banks and customers. The valuation of loans and
lending commitments also takes into account fee income that is considered an attribute of the contract.
Corporate loans and lending commitments are generally categorized in Level 2 of the fair value
hierarchy; in instances where prices or significant spread inputs are unobservable, they are categorized in
Level 3 of the fair value hierarchy.
• Mortgage Loans. Mortgage loans are valued using observable prices based on transactional data for
identical or comparable instruments, when available. Where observable prices are not available, the
Company estimates fair value based on benchmarking to prices and rates observed in the primary market
for similar loan or borrower types or based on the present value of expected future cash flows using its
best estimates of the key assumptions, including forecasted credit losses, prepayment rates, forward yield
curves and discount rates commensurate with the risks involved or a methodology that utilizes the capital
structure and credit spreads of recent comparable securitization transactions. Mortgage loans valued
based on observable transactional data for identical or comparable instruments are categorized in Level 2
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