Discover 2015 Annual Report Download - page 158

-142-
• Forward delivery contracts. Under the Company's risk management policy, the Company economically
hedged 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
were 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 were valued based primarily on observable inputs related to
characteristics of the underlying MBS stratified by product, coupon and settlement date. Therefore, these
derivatives were classified as Level 2. Best-efforts forward delivery contracts were valued based on investor
pricing tables, which were observable inputs, stratified by product, note rate and term, adjusted for current
market conditions. An anticipated loan funding probability was applied to value best-efforts contracts
hedging IRLCs, which resulted 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, were the most
significant assumptions affecting the value of the best-efforts contracts. The best-efforts forward delivery
contracts hedging loans held for sale were classified as Level 2, so such contracts were transferred from Level
3 to Level 2 at the time the underlying loan was originated.
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 elected to account for mortgage loans held for sale at fair value. Electing the fair value option
allowed for 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, 2015, there was no aggregate unpaid principal balance or fair value for loans held for sale for which
fair value option had been elected. At December 31, 2014, the aggregate unpaid principal balance of loans held for
sale for which the fair value option had been elected was $117 million and the fair value for such loans is $122 million.
For the years ended December 31, 2015 and 2014, $17 million and $18 million of losses, respectively, from fair value
adjustments on mortgage loans held for sale were recorded in other income on the consolidated statements of income.