eTrade 2012 Annual Report Download - page 125

The Company considers the price transparency for non-agency CMOs to be a key determinant of the degree
of judgment involved in determining the fair value. As of December 31, 2012, the Company’s non-agency CMOs
were categorized in Level 2 and Level 3 of the fair value hierarchy. The Company’s portfolio management group
determines the fair value measurements using a discounted cash flow methodology for non-agency CMOs on a
monthly basis with market observable data to the extent available, and a pricing service is utilized to corroborate
the market observability of significant inputs. The fair value measurements, valuation techniques and level
classification methodology are reviewed and compared to prior periods on a quarterly basis by management from
the finance, credit, enterprise risk management and compliance departments.
The significant inputs used in the fair value measurement of non-agency CMOs are yield, default rate, loss
severity and prepayment rate. Significant changes in any of those inputs in isolation would result in a significant
change in the fair value. Generally, an increase in the yield, default rate or loss severity in isolation would result
in a decrease in the fair value, and an increase in the prepayment rate would result in an increase in the fair value.
In addition, an increase in the assumption used for the prepayment rate generally will result in an increase in
yield.
The following table presents additional information about the underlying loans and significant inputs used in
discounted cash flow methodologies for the valuation of non-agency CMOs that were categorized in Level 3 of
the fair value hierarchy as of December 31, 2012:
Weighted
Average Range
Underlying loans:
Coupon rate 3.51% 2.56%-6.83%
Maturity (years) 21 14-25
Significant inputs:
Yield 4% 2%-16%
Default rate(1) 12% 1%-61%
Loss severity 42% 19%-100%
Prepayment rate 10% 0%-87%
(1) The default rate reflects the implied rate necessary to equate market price to the book yield given the market credit assumption.
Other Debt Securities
The fair value measurements of agency debt securities were determined using market and income
approaches along with the Company’s own trading activities for identical or similar instruments and were
categorized in Level 2 of the fair value hierarchy.
The Company’s municipal bonds are revenue bonds issued by state and other local government agencies.
The valuation of corporate bonds is impacted by the credit worthiness of the corporate issuer. The majority of the
Company’s municipal bonds and corporate bonds were rated investment grade as of December 31, 2012. These
securities were valued using a market approach with pricing service valuations corroborated by recent market
transactions for identical or similar bonds. Municipal bonds and corporate bonds were categorized in Level 2 of
the fair value hierarchy.
Derivative Instruments
Interest rate swap and option contracts were valued with an income approach using pricing models that are
commonly used by the financial services industry. The market observable inputs used in the pricing models
include the swap curve, the volatility surface, and prime or overnight indexed swap basis from a financial data
provider. The Company does not consider these models to involve significant judgment on the part of
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