Fifth Third Bank 2014 Annual Report Download - page 157

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
155 Fifth Third Bancorp
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.
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 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 DCF 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, foreign
exchange and commodity 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, 2014 and 2013, 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
IRLCs, 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 at an
exercise price of $15.98 per unit and requires settlement 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; conversely, 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 DCF 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;
conversely, 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 IRLCs at December 31, 2014
was $12 million. Immediate decreases in current interest rates of 25
bps and 50 bps would result in increases in the fair value of the
IRLCs of approximately $5 million and $9 million, respectively.
Immediate increases of current interest rates of 25 bps and 50 bps
would result in decreases in the fair value of the IRLCs of
approximately $5 million and $11 million, respectively. The decrease
in fair value of IRLCs 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.