US Bank 2009 Annual Report Download - page 114

backed securities, collateralized debt obligations and
collateralized loan obligations, and certain corporate debt
securities. In 2009, due to the limited number of trades of
non-agency mortgage-backed securities and lack of reliable
evidence about transaction prices, the Company determined
the fair value of these securities using a cash flow
methodology and incorporating observable market
information, where available. The use of a cash flow
methodology resulted in the Company transferring some
non-agency mortgage-backed securities to Level 3. This
transfer did not impact earnings and was not significant to
shareholders’ equity of the Company or the carrying amount
of the securities.
Cash flow methodologies and other market valuation
techniques involving management judgment use assumptions
regarding housing prices, interest rates and borrower
performance. Inputs are refined and updated to reflect
market developments. The primary valuation drivers of these
securities are the prepayment rates, default rates and default
severities associated with the underlying collateral, as well as
the discount rate used to calculate the present value of the
projected cash flows.
The following table shows the valuation assumption ranges for Level 3 non-agency mortgage-backed securities at December 31,
2009:
Minimum Maximum Average Minimum Maximum Average
Prime (a) Non-prime
Estimated prepayment rates . . . . . . . . . . . . . 4% 18% 13% 1% 13% 7%
Probability of default rates . . . . . . . . . . . . . . – 10 1 – 28 7
Loss severity rates . . . . . . . . . . . . . . . . . . . – 100 47 10 100 55
Discount margin . . . . . . . . . . . . . . . . . . . . . 3 25 6 3 31 13
(a) Prime securities are those designated as such by the issuer or those with underlying asset characteristics and/or credit enhancements consistent with securities designated as prime.
Certain mortgage loans held for sale MLHFS measured at
fair value, for which an active secondary market and readily
available market prices exist, are initially valued at the
transaction price and are subsequently valued by comparison
to instruments with similar collateral and risk profiles.
Included in mortgage banking revenue for the year ended
December 31, 2009 and 2008, was $206 million of net gains
and $65 million of net losses, respectively, from the initial
measurement and subsequent changes to fair value of these
MLHFS under fair value option accounting guidance.
Changes in fair value due to instrument specific credit risk
were immaterial. The fair value of MLHFS was $4.3 billion
as of December 31, 2009, which exceeded the unpaid
principal balance by $63 million as of that date. MLHFS are
Level 2. Related interest income for MLHFS is measured
based on contractual interest rates and reported as interest
income in the Consolidated Statement of Income. Electing to
measure MLHFS at fair value reduces certain timing
differences and better matches changes in fair value of these
assets with changes in the value of the derivative instruments
used to economically hedge them without the burden of
complying with the requirements for hedge accounting.
Loans The loan portfolio includes adjustable and fixed-rate
loans, the fair value of which was estimated using
discounted cash flow analyses and other valuation
techniques. To calculate discounted cash flows, the loans
were aggregated into pools of similar types and expected
repayment terms. The expected cash flows of loans
considered historical prepayment experiences and estimated
credit losses for nonperforming loans and were discounted
using current rates offered to borrowers of similar credit
characteristics. Generally, loan fair values reflect Level 3
information.
Mortgage servicing rights MSRs are valued using a cash
flow methodology and third party prices, if available.
Accordingly, MSRs are classified in Level 3. The Company
determines fair value by estimating the present value of the
asset’s future cash flows using market-based prepayment
rates, discount rates, and other assumptions validated
through comparison to trade information, industry surveys,
and independent third party appraisals. Risks inherent in
MSRs valuation include higher than expected prepayment
rates and/or delayed receipt of cash flows.
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 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
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