US Bank 2015 Annual Report Download - page 138

compared to fair values provided by third party pricing
services and broker provided quotes, where available.
Securities classified within Level 3 include non-agency
mortgage-backed securities, non-agency commercial
mortgage-backed securities, certain asset-backed securities,
certain collateralized debt obligations and collateralized loan
obligations and certain corporate debt securities.
Mortgage Loans Held For Sale MLHFS measured at fair
value, for which an active secondary market and readily
available market prices exist, are initially valued at the
transaction price and are subsequently valued by comparison
to instruments with similar collateral and risk profiles. MLHFS
are classified within Level 2. Included in mortgage banking
revenue was a $27 million net gain, a $185 million net gain
and a $335 million net loss for the years ended December 31,
2015, 2014 and 2013, respectively, from the changes to fair
value of these MLHFS under fair value option accounting
guidance. Changes in fair value due to instrument specific
credit risk were immaterial. Interest income for MLHFS is
measured based on contractual interest rates and reported as
interest income on the Consolidated Statement of Income.
Electing to measure MLHFS at fair value reduces certain
timing differences and better matches changes in fair value of
these assets with changes in the value of the derivative
instruments used to economically hedge them without the
burden of complying with the requirements for hedge
accounting.
Loans The loan portfolio includes adjustable and fixed-rate
loans, the fair value of which is estimated using discounted
cash flow analyses and other valuation techniques. The
expected cash flows of loans consider historical prepayment
experiences and estimated credit losses and are discounted
using current rates offered to borrowers with similar credit
characteristics. Generally, loan fair values reflect Level 3
information. Fair value is provided for disclosure purposes
only, with the exception of impaired collateral-based loans
that are measured at fair value on a non-recurring basis
utilizing the underlying collateral fair value.
Mortgage Servicing Rights MSRs are valued using a
discounted cash flow methodology, and are classified within
Level 3. The Company determines fair value by estimating the
present value of the asset’s future cash flows using
prepayment rates, discount rates, and other assumptions.
The MSR valuations, as well as the assumptions used, are
developed by the mortgage banking division and are subject
to review by senior management in corporate functions, who
are independent from the modeling. The MSR valuations and
assumptions are validated through comparison to trade
information when available, publicly available data and
industry surveys and are also compared to independent third
party valuations each quarter. Risks inherent in MSR valuation
include higher than expected prepayment rates and/or
delayed receipt of cash flows. There is minimal observable
market activity for MSRs on comparable portfolios, and,
therefore the determination of fair value requires significant
management judgment. Refer to Note 10 for further
information on MSR valuation assumptions.
Derivatives The majority of derivatives held by the Company
are executed over-the-counter and are valued using standard
cash flow, Black-Derman-Toy and Monte Carlo valuation
techniques. The models incorporate inputs, depending on the
type of derivative, including interest rate curves, foreign
exchange rates and volatility. In addition, all derivative values
incorporate an assessment of the risk of counterparty
nonperformance, measured based on the Company’s
evaluation of credit risk as well as external assessments of
credit risk, where available. The Company monitors and
manages its nonperformance risk by considering its ability to
net derivative positions under master netting arrangements,
as well as collateral received or provided under collateral
arrangements. Accordingly, the Company has elected to
measure the fair value of derivatives, at a counterparty level,
on a net basis. The majority of the derivatives are classified
within Level 2 of the fair value hierarchy, as the significant
inputs to the models, including nonperformance risk, are
observable. However, certain derivative transactions are with
counterparties where risk of nonperformance cannot be
observed in the market, and therefore the credit valuation
adjustments result in these derivatives being classified within
Level 3 of the fair value hierarchy. The credit valuation
adjustments for nonperformance risk are determined by the
Company’s treasury department using credit assumptions
provided by the risk management department. The credit
assumptions are compared to actual results quarterly and are
recalibrated as appropriate.
The Company also has other derivative contracts that are
created through its operations, including commitments to
purchase and originate mortgage loans and swap
agreements executed in conjunction with the sale of a portion
of its Class B common shares of Visa Inc. (“the Visa swaps”).
The mortgage loan commitments are valued by pricing
models that include market observable and unobservable
inputs, which result in the commitments being classified within
Level 3 of the fair value hierarchy. The unobservable inputs
include assumptions about the percentage of commitments
that actually become a closed loan and the MSR value that is
inherent in the underlying loan value, both of which are
developed by the Company’s mortgage banking division. The
closed loan percentages for the mortgage loan commitments
are monitored on an on-going basis, as these percentages
are also used for the Company’s economic hedging activities.
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