US Bank 2008 Annual Report Download - page 104

paid to transfer a liability (an exit price) in the principal or
most advantageous market for the asset or liability in an
orderly transaction between market participants on the
measurement date. Under SFAS 157, a fair value
measurement should reflect assumptions market participants
would use in pricing the asset or liability, including
assumptions about the risk inherent in a particular valuation
technique, the effect of a restriction on the sale or use of an
asset, and the risk of nonperformance. Upon adoption of
SFAS 157, the Company considered the principal market
and nonperformance risk when determining the fair value
measurements for derivatives which reduced trading revenue
by $62 million. SFAS 157 no longer allows the deferral of
origination fees or compensation expense related to the
closing of MLHFS for which the fair value option is elected,
resulting in additional mortgage banking revenue and
compensation expense in the period the MLHFS are
originated.
SFAS 157 specifies a three level hierarchy for valuation
techniques used to measure financial assets and financial
liabilities at fair value. This hierarchy is based on whether
the valuation inputs are observable or unobservable. These
levels are:
• Level 1 — Quoted prices in active markets for identical
assets or liabilities. Level 1 includes U.S. Treasury and
exchange-traded instruments.
• Level 2 — Observable inputs other than Level 1 prices,
such as quoted prices for similar assets or liabilities;
quoted prices in markets that are not active; or other
inputs that are observable or can be corroborated by
observable market data for substantially the full term of
the assets or liabilities. Level 2 includes debt securities
that are traded less frequently than exchange-traded
instruments and which are valued using third party
pricing services; derivative contracts whose value is
determined using a pricing model with inputs that are
observable in the market or can be derived principally
from or corroborated by observable market data; and
MLHFS whose values are determined using quoted prices
for similar assets or pricing models with inputs that are
observable in the market or can be corroborated by
observable market data.
• Level 3 — Unobservable inputs that are supported by
little or no market activity and that are significant to the
fair value of the assets or liabilities. Level 3 assets and
liabilities include financial instruments whose values are
determined using pricing models, discounted cash flow
methodologies, or similar techniques, as well as
instruments for which the determination of fair value
requires significant management judgment or estimation.
This category includes residential MSRs, certain debt
securities, including the Company’s SIV-related
investments and certain of its non-agency mortgage-
backed securities, and certain derivative contracts.
The following section describes the valuation methodologies
used by the Company to measure financial assets and
liabilities at fair value and for estimating fair value for
financial instruments not recorded at fair value as required
under SFAS 107 (“SFAS 107”), “Disclosures about Fair
Value of Financial Instruments”. In addition, for financial
assets and liabilities measured at fair value, the following
section includes an indication of the level of the fair value
hierarchy in which the assets or liabilities are classified.
Where appropriate, the description includes information
about the valuation models and key inputs to those models.
Derivatives Exchange-traded derivatives are measured at fair
value based on quoted market (i.e. exchange) prices. Because
prices are available for the identical instrument in an active
market, these fair values are classified within Level 1 of the
fair value hierarchy.
The majority of derivatives held by the Company are
executed over-the-counter and are valued using standard
cash flow, Black-Scholes and Monte Carlo valuation
techniques. The models incorporate various inputs,
depending on the type of derivative, including interest rate
curves, foreign exchange rates and volatility. In addition, all
derivative values incorporate an assessment of the risk of
counterparty nonperformance which is measured based on
the Company’s evaluation of credit risk and incorporates
external assessments of credit risk, where available. In its
assessment of nonperformance risk, the Company considers
its ability to net derivative positions under master netting
agreements, as well as collateral received or provided under
collateral support agreements. The majority of these
derivatives are classified within Level 2 of the fair value
hierarchy as the significant inputs to the models are
observable. An exception to the Level 2 classification are
certain derivative transactions for which the risk of
nonperformance cannot be observed in the market. These
derivatives are classified within Level 3 of the fair value
hierarchy. In addition, commitments to sell, purchase and
originate mortgage loans that meet the requirements of a
derivative, are valued by pricing models that include market
observable and unobservable inputs. Due to the significant
unobservable inputs, these commitments are classified within
Level 3 of the fair value hierarchy.
Cash and Cash Equivalents The carrying value of cash,
amounts due from banks, federal funds sold and securities
purchased under resale agreements was assumed to
approximate fair value.
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