Fifth Third Bank 2009 Annual Report Download - page 21

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fifth Third Bancorp 19
evaluates and assesses the relative risks and appropriate tax
treatment of transactions and filing positions after considering
statutes, regulations, judicial precedent and other information and
maintains tax accruals consistent with its evaluation of these
relative risks and merits. Changes to the estimate of accrued taxes
occur periodically due to changes in tax rates, interpretations of
tax laws, the status of examinations being conducted by taxing
authorities and changes to statutory, judicial and regulatory
guidance that impact the relative risks of tax positions. These
changes, when they occur, can affect deferred taxes and accrued
taxes as well as the current period’s income tax expense and can
be significant to the operating results of the Bancorp. For
additional information on income taxes, see Note 20 of the Notes
to Consolidated Financial Statements.
Valuation of Servicing Rights
When the Bancorp sells loans through either securitizations or
individual loan sales in accordance with its investment policies, it
often obtains servicing rights. Servicing rights resulting from loan
sales are initially recorded at fair value and subsequently amortized
in proportion to, and over the period of, estimated net servicing
income. Servicing rights are assessed for impairment monthly,
based on fair value, with temporary impairment recognized
through a valuation allowance and permanent impairment
recognized through a write-off of the servicing asset and related
valuation allowance. Key economic assumptions used in
measuring any potential impairment of the servicing rights include
the prepayment speeds of the underlying loans, the weighted-
average life, the discount rate, the weighted-average coupon and
the weighted-average default rate, as applicable. The primary risk
of material changes to the value of the servicing rights resides in
the potential volatility in the economic assumptions used,
particularly the prepayment speeds.
The Bancorp monitors risk and adjusts its valuation
allowance as necessary to adequately reserve for impairment in the
servicing portfolio. For purposes of measuring impairment, the
mortgage servicing rights are stratified into classes based on the
financial asset type and interest rates. Fees received for servicing
loans owned by investors are based on a percentage of the
outstanding monthly principal balance of such loans and are
included in noninterest income in the Consolidated Statements of
Income as loan payments are received. Costs of servicing loans are
charged to expense as incurred. For additional information on
servicing rights, see Note 11 of the Notes to Consolidated
Financial Statements.
Fair Value Measurements
The Bancorp measures fair value in accordance with U.S. GAAP,
which defines fair value as the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. Valuation
techniques the Bancorp uses to measure fair value include the
market approach, income approach and cost approach. The
market approach uses prices or relevant information generated by
market transactions involving identical or comparable assets or
liabilities. The income approach involves discounting future
amounts to a single present amount and is based on current
market expectations about those future amounts. The cost
approach is based on the amount that currently would be required
to replace the service capacity of the asset.
U.S. GAAP establishes a fair value hierarchy, which
prioritizes the inputs to valuation techniques used to measure fair
value into three broad levels. The fair value hierarchy gives the
highest priority to quoted prices in active markets for identical
assets or liabilities (Level 1) and the lowest priority to
unobservable inputs (Level 3). An instrument’s categorization
within the fair value hierarchy is based upon the lowest level of
input that is significant to the instrument’s fair value
measurement. The three levels within the fair value hierarchy are
described as follows:
Level 1 - Quoted prices (unadjusted) in active markets
for identical assets or liabilities that the Bancorp has the
ability to access at the measurement date.
Level 2 - Inputs other than quoted prices included within
Level 1 that are observable for the asset or liability,
either directly or indirectly. Level 2 inputs include:
quoted prices for similar assets or liabilities in active
markets; quoted prices for identical or similar assets or
liabilities in markets that are not active; inputs other
than quoted prices that are observable for the asset or
liability; and inputs that are derived principally from or
corroborated by observable market data by correlation
or other means.
Level 3 - Unobservable inputs for the asset or liability for
which there is little, if any, market activity at the
measurement date. Unobservable inputs reflect the
Bancorp’s own assumptions about what market
participants would use to price the asset or liability. The
inputs are developed based on the best information
available in the circumstances, which might include the
Bancorp’s own financial data such as internally
developed pricing models and discounted cash flow
methodologies, as well as instruments for which the fair
value determination requires significant management
judgment.
The Bancorp's fair value measurements involve various
valuation techniques and models, which involve inputs that are
observable, when available, and include the following significant
instruments: available-for-sale and trading securities, residential
mortgage loans held for sale and certain derivatives. The following
is a summary of valuation techniques utilized by the Bancorp for
its significant assets and liabilities measured at fair value on a
recurring basis.
Available-for-sale and trading securities
Where quoted prices are available in an active market,
securities are classified within Level 1 of the valuation
hierarchy. Level 1 securities include government bonds
and exchange traded equities. If quoted market prices
are not available, then fair values are estimated using
pricing models, quoted prices of securities with similar
characteristics, or discounted cash flows. Examples of
such instruments, which would generally be classified
within Level 2 of the valuation hierarchy, include
corporate and municipal bonds, mortgage-backed
securities, asset-backed securities and Variable Rate
Demand Notes (VRDNs). In certain cases where there
is limited activity or less transparency around inputs to
the valuation, securities are classified within Level 3 of
the valuation hierarchy. Securities classified within Level
3 consist primarily of residual interests in securitizations
of automobile loans. These residual interests are valued
using discounted cash flow models that integrate
significant unobservable inputs, including discount rates,
prepayment speeds, and loss rates which are estimated
based on actual performance of similar loans transferred
in previous securitizations. Trading securities classified
as Level 3 consist of auction rate securities. Due to the
illiquidity in the market for these types of securities at
December 31, 2009, the Bancorp measured fair value
using a discount rate commensurate with the assumed
holding period.