Morgan Stanley 2014 Annual Report Download - page 179

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
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 position-specific external price data are not observable, fair value is
determined based on either benchmarking to similar instruments or 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 and Loan Obligations. The Company holds cash collateralized debt obligations
(“CDOs”)/collateralized loan obligations (“CLOs”) that typically reference a tranche of an underlying
synthetic portfolio of single name credit default swaps collateralized by corporate bonds (“credit-linked
notes”) or cash portfolio of asset-backed securities/loans (“asset-backed CDOs/CLOs”). Credit
correlation, a primary input used to determine the fair value of credit-linked notes, is usually
unobservable and derived using a benchmarking technique. The other credit-linked note model inputs
such as credit spreads, including collateral spreads, and interest rates are typically observable. Asset-
backed CDOs/CLOs are valued based on an evaluation of the market and model input parameters sourced
from similar positions as indicated by primary and secondary market activity. Each asset-backed CDO/
CLO position is evaluated independently taking into consideration available comparable market levels,
underlying collateral performance and pricing, deal structures, and liquidity. Cash CDOs/CLOs are
categorized in Level 2 of the fair value hierarchy when either the credit correlation input is insignificant
or comparable market transactions are observable. In instances where the credit correlation input is
deemed to be significant or comparable market transactions are unobservable, cash CDOs/CLOs 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 categorized in Level 2 of the fair value hierarchy except in
instances where prices or significant spread inputs are unobservable, in which case they are categorized in
Level 3 of the fair value hierarchy.
• Mortgage Loans. Mortgage loans are valued using observable prices based on transactional data or
third-party pricing for identical or comparable instruments, when available. Where position-specific
external prices are not observable, 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 market data for identical or comparable
instruments are categorized in Level 2 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
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