US Bank 2012 Annual Report Download - page 129

Investment Securities When quoted market prices for identical
securities are available in an active market, these prices are
used to determine fair value and these securities are classified
within Level 1 of the fair value hierarchy. Level 1 investment
securities are predominantly U.S. Treasury securities.
For other securities, quoted market prices may not be
readily available for the specific securities. When possible, the
Company determines fair value based on market observable
information, including quoted market prices for similar
securities, inactive transaction prices, and broker quotes.
These securities are classified within Level 2 of the fair value
hierarchy. Level 2 valuations are generally provided by a third
party pricing service. The Company reviews the valuation
methodologies utilized by the pricing service and, on a
quarterly basis, reviews the security level prices provided by
the pricing service against management’s expectation of fair
value, based on changes in various benchmarks and market
knowledge from recent trading activity. Additionally, each
quarter, the Company validates the fair value provided by the
pricing services by comparing them to recent observable
market trades (where available), broker provided quotes, or
other independent secondary pricing sources. Prices obtained
from the pricing service are adjusted if they are found to be
inconsistent with observable market data. Level 2 investment
securities are predominantly agency mortgage-backed
securities, certain other asset-backed securities, municipal
securities, corporate debt securities, agency debt securities and
perpetual preferred securities.
The fair value of securities for which there are no market
trades, or where trading is inactive as compared to normal
market activity, are classified within Level 3 of the fair value
hierarchy. The Company determines the fair value of these
securities using a discounted cash flow methodology and
incorporating observable market information, where
available. These valuations are modeled by a unit within the
Company’s treasury department. The valuations use
assumptions regarding housing prices, interest rates and
borrower performance. Inputs are refined and updated at least
quarterly to reflect market developments and actual
performance. 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 review by senior management
in corporate functions, who are independent from the
modeling. The fair value measurements are also compared 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.
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 $287
million net gain, a $15 million net gain and a $125 million net
loss, for the years ended December 31, 2012, 2011 and 2010,
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 and were discounted
using current rates offered to borrowers of similar credit
characteristics. Generally, loan fair values reflect Level 3
information. Fair value is provided for disclosure purposes
only, with the exception of impaired collateral-based loans
that are measured at fair value on a non-recurring basis
utilizing the underlying collateral fair value.
Mortgage Servicing Rights MSRs are valued using a discounted
cash flow methodology. 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 prepayment rates, discount rates, and other assumptions.
The MSR valuations, as well as the assumptions used, are
developed by the mortgage banking division and are subject to
review by senior management in corporate functions, who are
independent from the modeling. The MSR valuations and
assumptions are validated through comparison to trade
information and industry surveys when available, and are also
compared to independent third party valuations each quarter.
Risks inherent in MSR valuation include higher than expected
prepayment rates and/or delayed receipt of cash flows. There is
minimal market activity for MSRs, therefore the determination
of fair value requires significant management judgment. Refer
to Note 9 for further information on MSR valuation
assumptions.
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