Fifth Third Bank 2010 Annual Report Download - page 24

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
22 Fifth Third Bancorp
31, 2010, the Bancorp measured fair value using a
discount rate based on the assumed holding period.
Residential mortgage loans held for sale and held
for investment
For residential mortgage loans held for sale, fair value is
estimated based upon mortgage-backed securities prices
and spreads to those prices or, for certain ARM loans,
discounted cash flow models that may incorporate the
anticipated portfolio composition, credit spreads of
asset-backed securities with similar collateral, and market
conditions. The anticipated portfolio composition
includes the effect of interest rate spreads and discount
rates due to loan characteristics such as the state in
which the loan was originated, the loan amount and the
ARM margin. Residential mortgage loans held for sale
that are valued based on mortgage-backed securities
prices are classified within Level 2 of the valuation
hierarchy as the valuation is based on external pricing
for similar instruments. ARM loans classified as held for
sale are also classified within Level 2 of the valuation
hierarchy due to the use of observable inputs in the
discounted cash flow model. These observable inputs
include interest rate spreads from agency mortgage-
backed securities market rates and observable discount
rates. For residential mortgage loans reclassified from
held for sale to held for investment, the fair value
estimation is based primarily on the underlying collateral
values. Therefore, these loans are classified within Level
3 of the valuation hierarchy.
Derivatives
Exchange-traded derivatives valued using quoted prices
and certain over-the-counter derivatives valued using
active bids are classified within Level 1 of the valuation
hierarchy. Most of the Bancorp’s derivative contracts are
valued using discounted cash flow or other models that
incorporate current market interest rates, credit spreads
assigned to the derivative counterparties, and other
market parameters and, therefore, are classified within
Level 2 of the valuation hierarchy. Such derivatives
include basic and structured interest rate swaps and
options. Derivatives that are valued based upon models
with significant unobservable market parameters are
classified within Level 3 of the valuation hierarchy. At
December 31, 2010, derivatives classified as Level 3,
which are valued using an option-pricing model
containing unobservable inputs, consisted primarily of
warrants and put rights associated with the Processing
Business Sale and a total return swap associated with the
Bancorp’s sale of its Visa, Inc. Class B shares. Level 3
derivatives also include interest rate lock commitments,
which utilize internally generated loan closing rate
assumptions as a significant unobservable input in the
valuation process.
Valuation techniques and parameters used for measuring
assets and liabilities are reviewed and validated by the Bancorp on
a quarterly basis. Additionally, the Bancorp monitors the fair
values of significant assets and liabilities using a variety of
methods including the evaluation of pricing runs and exception
reports based on certain analytical criteria, comparison to previous
trades and overall review and assessments for reasonableness.
In addition to the assets and liabilities measured at fair value
on a recurring basis, the Bancorp measures servicing rights,
certain loans and long-lived assets at fair value on a nonrecurring
basis. Refer to Note 28 of the Notes to Consolidated Financial
Statements for further information on fair value measurements.
Goodwill
Business combinations entered into by the Bancorp typically
include the acquisition of goodwill. U.S. GAAP requires goodwill
to be tested for impairment at the Bancorp’s reporting unit level
on an annual basis, which for the Bancorp is September 30, and
more frequently if events or circumstances indicate that there may
be impairment. The Bancorp has determined that its segments
qualify as reporting units under U.S. GAAP. Impairment exists
when a reporting unit’s carrying amount of goodwill exceeds its
implied fair value, which is determined through a two-step
impairment test. The first step (Step 1) compares the fair value of
a reporting unit with its carrying amount, including goodwill. If
the carrying amount of the reporting unit exceeds its fair value,
the second step (Step 2) of the goodwill impairment test is
performed to measure the impairment loss amount, if any.
The fair value of a reporting unit is the price that would be
received to sell the unit as a whole in an orderly transaction
between market participants at the measurement date. Since none
of the Bancorp’s reporting units are publicly traded, individual
reporting unit fair value determinations cannot be directly
correlated to the Bancorp’s stock price. To determine the fair
value of a reporting unit, the Bancorp employs an income-based
approach, utilizing the reporting unit’s forecasted cash flows
(including a terminal value approach to estimate cash flows
beyond the final year of the forecast) and the reporting unit’s
estimated cost of equity as the discount rate. Additionally, the
Bancorp determines its market capitalization based on the average
of the closing price of the Bancorp's stock during the month
including the measurement date, incorporating an additional
control premium, and allocates this market-based fair value
measurement to the Bancorp's reporting units in order to
corroborate the results of the income approach.
When required to perform Step 2, the Bancorp compares the
implied fair value of a reporting unit’s goodwill with the carrying
amount of that goodwill. If the carrying amount exceeds the
implied fair value, an impairment loss equal to that excess amount
is recognized. An impairment loss recognized cannot exceed the
carrying amount of that goodwill and cannot be reversed even if
the fair value of the reporting unit recovers.
During Step 2, the Bancorp determines the implied fair value
of goodwill for a reporting unit by assigning the fair value of the
reporting unit to all of the assets and liabilities of that unit
(including any unrecognized intangible assets) as if the reporting
unit had been acquired in a business combination. The excess of
the fair value of the reporting unit over the amounts assigned to
its assets and liabilities is the implied fair value of goodwill. This
assignment process is only performed for purposes of testing
goodwill for impairment. The Bancorp does not adjust the
carrying values of recognized assets or liabilities (other than
goodwill, if appropriate), nor recognize previously unrecognized
intangible assets in the Consolidated Financial Statements as a
result of this assignment process. Refer to Note 10 of the Notes
to Consolidated Financial Statements for further information
regarding the Bancorp’s goodwill.