US Bank 2011 Annual Report Download - page 118

securities using a cash flow methodology and incorporating
observable market information, where available. 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. Level 3 fair values, including the
assumptions used, are subject to an independent internal
review, including a comparison to fair values provided by
third party pricing services, where available. Securities
classified within Level 3 include non-agency mortgage-backed
securities, non-agency commercial mortgage-backed securities,
certain asset-backed securities, certain collateralized debt
obligations and collateralized loan obligations, certain
corporate debt securities and SIV-related securities. Beginning
in the first quarter of 2009, due to the limited number of
trades of non-agency mortgage-backed securities and lack of
reliable evidence about transaction prices, the Company began
determining 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 in the first
quarter of 2009. This transfer did not impact earnings and
was not significant to shareholders’ equity of the Company or
the carrying amount of the securities.
The following table shows the valuation assumption ranges for Level 3 available-for-sale non-agency mortgage-backed securities:
Prime (a) Non-prime
Minimum Maximum Average Minimum Maximum Average
December 31, 2011
Estimated lifetime prepayment rates ..................... 4% 23% 13% 1% 13% 6%
Lifetime probability of default rates ....................... – 14 2 – 20 7
Lifetime loss severity rates ............................... 9 80 39 8 88 54
Discount margin .......................................... 3 36 7 5 40 11
December 31, 2010
Estimated lifetime prepayment rates ..................... 4% 28% 13% 1% 13% 6%
Lifetime probability of default rates ....................... – 14 1 – 20 8
Lifetime loss severity rates ............................... 16 100 41 10 88 56
Discount margin .......................................... 3 30 6 3 40 11
(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.
MLHFS are classified within Level 2. Included in mortgage
banking revenue was a $15 million net gain, a $125 million
net loss and a $206 million net gain, for the years ended
December 31, 2011, 2010 and 2009, respectively, from the
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. 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. 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 within 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 valuations. Risks
inherent in MSRs valuation include higher than expected
prepayment rates and/or delayed receipt of cash flows. Refer
to Note 10 for further information on MSR valuation
assumptions.
Derivatives 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
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