Fifth Third Bank 2013 Annual Report Download - page 159

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
157 Fifth Third Bancorp
mortgage-backed securities market rates and observable discount
rates.
Residential mortgage loans
Residential mortgage loans held for sale that are reclassified to held
for investment are transferred from Level 2 to Level 3 of the fair
value hierarchy. It is the Bancorp’s policy to value any transfers
between levels of the fair value hierarchy based on end of period
fair values.
For residential mortgage loans reclassified from held for sale to
held for investment, the fair value estimation is based on mortgage-
backed securities prices, interest rate risk and an internally
developed credit component. Therefore, these loans are classified
within Level 3 of the valuation hierarchy. An adverse change in the
loss rate or severity assumption would result in a decrease in fair
value of the related loan. The Secondary Marketing Department,
which reports to the Bancorp’s Chief Operating Officer, in
conjunction with the Consumer Credit Risk Department, which
reports to the Bancorp’s Chief Risk and Credit Officer, are
responsible for determining the valuation methodology for
residential mortgage loans held for investment. The Secondary
Marketing Department reviews loss severity assumptions quarterly
to determine if adjustments are necessary based on decreases in
observable housing market data. This group also reviews trades in
comparable benchmark securities and adjusts the values of loans as
necessary. Consumer Credit Risk is responsible for the credit
component of the fair value which is based on internally developed
loss rate models that take into account historical loss rates and loss
severities based on underlying collateral values.
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, 2013 and 2012, derivatives classified as Level 3, which are valued
using models containing unobservable inputs, consisted primarily of
a warrant associated with the initial sale of the Bancorp’s 51%
interest in Vantiv Holding, LLC 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.
The warrant allows the Bancorp to purchase approximately 20
million incremental nonvoting units in Vantiv Holding, LLC under
certain defined conditions involving change of control. The fair
value of the warrant is calculated in conjunction with a third party
valuation provider by applying Black-Scholes option valuation
models using probability weighted scenarios which contain the
following inputs: Vantiv, Inc. stock price, strike price per the
Warrant Agreement and several unobservable inputs, such as
expected term, expected volatility, and expected dividend rate.
For the warrant, an increase in the expected term (years) and
the expected volatility assumptions would result in an increase in the
fair value; correspondingly, a decrease in these assumptions would
result in a decrease in the fair value. The Accounting and Treasury
Departments, both of which report to the Bancorp’s Chief Financial
Officer, determined the valuation methodology for the warrant.
Accounting and Treasury review changes in fair value on a quarterly
basis for reasonableness based on changes in historical and implied
volatilities, expected terms, probability weightings of the related
scenarios, and other assumptions.
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.
Additionally, the Bancorp will make a quarterly payment based on
Visa’s stock price and the conversion rate of the Visa, Inc. Class B
shares into Class A shares until the date on which the Covered
Litigation is settled. 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, the timing of the
resolution of the Covered Litigation and Visa litigation loss
estimates in excess, or shortfall, of the Bancorp’s proportional share
of escrow funds.
An increase in the loss estimate or a delay in the resolution of
the Covered Litigation would result in an increase in fair value;
correspondingly, a decrease in the loss estimate or an acceleration of
the resolution of the Covered Litigation would result in a decrease
in fair value. The Accounting and Treasury Departments
determined the valuation methodology for the total return swap.
Accounting and Treasury review the changes in fair value on a
quarterly basis for reasonableness based on Visa stock price
changes, litigation contingencies, and escrow funding.
The net fair value asset of the interest rate lock commitments
at December 31, 2013 was $11 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 $8 million and $15 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 $9 million and $18 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 $1 million and $2 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 $1 million and $2 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.
The Secondary Marketing Department and the Consumer Line
of Business Finance Department, which reports to the Bancorp’s
Chief Financial Officer, are responsible for determining the
valuation methodology for IRLCs. Secondary Marketing, in
conjunction with a third party valuation provider, periodically
review loan closing rate assumptions and recent loan sales to
determine if adjustments are needed for current market conditions
not reflected in historical data.