Fifth Third Bank 2011 Annual Report Download - page 141

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp 139
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 DCF 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 on
mortgage-backed securities prices and a credit component that is
based on internally developed loss rate models. 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 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, 2011 and 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 sale of the processing
business to Advent International and a total return swap associated
with the Bancorp’s sale of 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.
In connection with the sale of the processing business, the
Bancorp provided Advent International with certain put options
that are exercisable in the event of certain circumstances. In
addition, the associated warrants allow the Bancorp to purchase an
incremental 10% nonvoting interest in Vantiv Holding, LLC under
certain defined conditions involving change of control. The fair
values of the warrants and put options are calculated applying
Black-Scholes option valuation models using probability weighted
scenarios. The assumptions utilized in the models are summarized
in the following table as of December 31:
2011 2010
Warrants Put Options (b) Warrants Put Options
Expected term (years) 7.5 -17.5 2.0 8.5 -18.5 0.5 -3.0
Expected volatility(a) 35.4 -35.5 %31.5 % 36.0 -37.0 %25.6 -44.6 %
Risk free rate 1.57 -2.88 %0.31 % 3.06 -4.18 %0.23 -1.05 %
Expected dividend rate - % - % - % - %
(a) Based on historical and implied volatilities of comparable companies assuming similar expected terms.
(b) Historically, three scenarios have been used to estimate the fair value of the put options. Two of the scenarios’ terms expired prior to December 31, 2011. Therefore, the assumptions at December 31,
2011 only include one scenario.
Under the terms of the total return swap, the Bancorp will make or
receive payments based on subsequent changes in the conversion
rate of the Visa, Inc. Class B shares into Class A shares. The fair
value of the total return swap was calculated using a discounted cash
flow model based on unobservable inputs consisting of
management’s estimate of the probability of certain litigation
scenarios, timing of litigation settlements and payments related to
the swap.
The net fair value of the interest rate lock commitments at
December 31, 2011 was $33 million. Immediate decreases in current
interest rates of 25 bps and 50 bps would result in increases in the
fair value of the interest rate lock commitments of approximately
$16 million and $28 million, respectively. Immediate increases of
current interest rates of 25 bps and 50 bps would result in decreases
in the fair value of the interest rate lock commitments of
approximately $20 million and $45 million, respectively. The
decrease in fair value of interest rate lock commitments due to
immediate 10% and 20% adverse changes in the assumed loan
closing rates would be approximately $4 million and $7 million,
respectively, and the increase in fair value due to immediate 10%
and 20% favorable changes in the assumed loan closing rates would
be approximately $3 million and $6 million, respectively. These
sensitivities are hypothetical and should be used with caution, as
changes in fair value based on a variation in assumptions typically
cannot be extrapolated because the relationship of the change in
assumptions to the change in fair value may not be linear.