Morgan Stanley 2010 Annual Report Download - page 153

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
of the fair value hierarchy. Where observable prices are not available, due to the subjectivity involved in
the comparability assessment related to mortgage loan vintage, geographical concentration, prepayment
speed and projected loss assumptions, mortgage loans are classified in Level 3 of the fair value hierarchy.
• Auction Rate Securities (“ARS”). The Company primarily holds investments in Student Loan Auction
Rate Securities (“SLARS”) and Municipal Auction Rate Securities (“MARS”) with interest rates that are
reset through periodic auctions. SLARS are ABS backed by pools of student loans. MARS are municipal
bonds often wrapped by municipal bond insurance. ARS were historically traded and valued as floating
rate notes, priced at par due to the auction mechanism. Beginning in fiscal 2008, uncertainties in the
credit markets have resulted in auctions failing for certain types of ARS. Once the auctions failed, ARS
could no longer be valued using observations of auction market prices. Accordingly, the fair value of
ARS is determined using independent external market data where available and an internally developed
methodology to discount for the lack of liquidity and non-performance risk.
Inputs that impact the valuation of SLARS are independent external market data, the underlying collateral
types, level of seniority in the capital structure, amount of leverage in each structure, credit rating and
liquidity considerations. Inputs that impact the valuation of MARS are independent external market data
when available, the maximum rate, quality of underlying issuers/insurers and evidence of issuer calls.
ARS are generally categorized in Level 2 of the fair value hierarchy as the valuation technique relies on
observable external data.
Corporate Equities.
• Exchange-Traded Equity Securities. Exchange-traded equity securities are generally valued based on
quoted prices from the exchange. To the extent these securities are actively traded, valuation adjustments
are not applied, and they are categorized in Level 1 of the fair value hierarchy; otherwise, they are
categorized in Level 2 or Level 3 of the fair value hierarchy.
Derivative and Other Contracts.
• Listed Derivative Contracts. Listed derivatives that are actively traded are valued based on quoted
prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Listed derivatives that
are not actively traded are valued using the same approaches as those applied to OTC derivatives; they are
generally categorized in Level 2 of the fair value hierarchy.
• OTC Derivative Contracts. OTC derivative contracts include forward, swap and option contracts related
to interest rates, foreign currencies, credit standing of reference entities, equity prices or commodity
prices.
Depending on the product and the terms of the transaction, the fair value of OTC derivative products can
be either observed or modeled using a series of techniques and model inputs from comparable
benchmarks, including closed-form analytic formulas, such as the Black-Scholes option-pricing model,
and simulation models or a combination thereof. Many pricing models do not entail material subjectivity
because the methodologies employed do not necessitate significant judgment, and the pricing inputs are
observed from actively quoted markets, as is the case for generic interest rate swaps, certain option
contracts and certain credit default swaps. In the case of more established derivative products, the pricing
models used by the Company are widely accepted by the financial services industry. A substantial
majority of OTC derivative products valued by the Company using pricing models fall into this category
and are categorized in Level 2 of the fair value hierarchy.
Other derivative products, including complex products that have become illiquid, require more judgment
in the implementation of the valuation technique applied due to the complexity of the valuation
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