KeyBank 2008 Annual Report Download - page 121

119
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS KEYCORP AND SUBSIDIARIES
119
Any changes to valuation methodologies are reviewed by management
to ensure they are appropriate and justified. Valuation methodologies are
refined as more market-based data becomes available.
FAIR VALUE HIERARCHY
SFAS No. 157 establishes a three-level valuation hierarchy for
determining fair value that is based on the transparency of the inputs
used in the valuation process. The inputs used in determining fair value
in each of the three levels of the hierarchy, from highest ranking to
lowest, are as follows:
•Level 1. Quoted prices in active markets for identical assets or
liabilities.
•Level 2. Either: (i) quoted market prices for similar assets or
liabilities; (ii) observable inputs, such as interest rates or yield
curves; or (iii) inputs derived principally from or corroborated by
observable market data.
•Level 3. Unobservable inputs.
The level in the fair value hierarchy ascribed to a fair value measurement
in its entirety is based on the lowest level input that is significant to the
overall fair value measurement.
QUALITATIVE DISCLOSURES
OF VALUATION TECHNIQUES
Loans. Loans recorded as trading account assets are valued based on
market spreads for identical or similar assets. Generally, these loans are
classified as Level 2 since the fair value recorded is based on observable
market data. Key corroborates these inputs periodically through a
pricing service, which obtains data about actual transactions in the
marketplace for identical or similar assets. However, at December 31,
2008, market data was not readily available for these loans, so Key
valued the loans using an internal model. Accordingly, these loans
were classified as Level 3 at December 31, 2008.
Securities (trading and available for sale). Where quoted prices are
available in an active market, securities are classified as Level 1. Level
1instruments include highly liquid government bonds, securities issued
by the U.S. Treasury and exchange-traded equity securities. If quoted
prices are not available, management determines fair value using pricing
models, quoted prices of similar securities or discounted cash flows.
These instruments include assets such as municipal bonds and certain
agency collateralized mortgage obligations, and are classified as Level 2.
Where there is limited activity in the market for a particular instrument,
management must make assumptions to determine fair value. Such
instruments include certain mortgage-backed securities, certain
commercial paper and restricted stock. These are classified as Level 3.
Private equity and mezzanine investments. Valuations of private equity
and mezzanine investments, held primarily within Key’s Real Estate
Capital and Corporate Banking Services line of business, are based
primarily on management’s judgment because of the lack of readily
determinable fair values, inherent illiquidity and the long-term nature
of these assets. These investments are initially valued based upon the
transaction price. The carrying amount is then adjusted based upon the
estimated future cash flows associated with the investments. Factors used
in determining future cash flows include, but are not limited to, the cost
of build-out, future selling prices, current market outlook and operating
performance of the particular investment. Private equity and mezzanine
investments are classified as Level 3.
Principal investments. Principal investments made by KPP include
direct investments (investments made in a particular company), as well
as indirect investments (investments made through funds that include
other investors). These investments include both equity securities and
those made in privately held companies. When quoted prices are
available in an active market, which is the case for most equity securities,
they are used in the valuation process and the related investments are
classified as Level 1 assets. However, in most cases, quoted market prices
are not available and management must rely upon other sources, such
as statements from the investment manager, price/earnings ratios and
multiples of earnings before interest, tax, depreciation and amortization
to perform the asset valuations. These investments have been classified
as Level 3 assets since management’s assumptions impact the overall
determination of fair value.
Derivatives. Exchange-traded derivatives are valued using quoted prices
and, therefore, are classified as Level 1. However, only a few types of
derivatives areexchange-traded, so the majority of Key’sderivative
positions are valued using internally developed models based on market
convention that uses observable market inputs. These derivative contracts
are classified as Level 2 and include interest rate swaps, options and
credit default swaps. Market convention implies a credit rating of
double-A equivalent in the pricing of derivative contracts, which
assumes all counterparties have the same creditworthiness. In order to
reflect the actual exposure on Key’s derivative contracts related to
both counterparty and Key’s own creditworthiness, management records
afair value adjustment in the form of a reserve. The credit component
is valued on a counterparty-by-counterparty basis, and considers master
netting agreements and collateral.
ASSETS AND LIABILITIES MEASURED
AT FAIR VALUE ON A RECURRING BASIS
Assets and liabilities are considered to be fair valued on a recurring basis
if fair value is measured regularly (i.e., daily,weekly, monthly or quarterly).