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notes to consolidated financial statements
american express company
85
(b) The interest-only strip is accounted for at fair value and is reported in other
assets on the Company’s Consolidated Balance Sheets with changes in fair
value recorded in securitization income, net in the Company’s Consolidated
Statements of Income.
The Company partially adopted SFAS No. 157 as of
January 1, 2008. SFAS No. 157 established a three-level
hierarchy of valuation techniques used to measure fair value.
Refer to Note 1 for additional discussion regarding each level
in the fair value hierarchy as defined by SFAS No. 157. The
Company classifies its subordinated securities and its interest-
only strip in Level 3 of the fair value hierarchy.
The Company determines the fair value of its retained
subordinated securities using discounted cash flow models.
The discount rate used is based on an interest rate curve
that is observable in the marketplace plus an unobservable
credit spread commensurate with the risk of these securities
and similar financial instruments. The Company classifies
such securities in Level 3 of the fair value hierarchy because
the applicable credit spreads are not observable due to the
illiquidity in the market with respect to these securities and
similar financial instruments.
The fair value of the interest-only strip is the present value of
estimated future positive excess spread expected to be generated
by the securitized loans over the estimated remaining life of those
loans. Management utilizes certain estimates and assumptions to
determine the fair value of the interest-only strip asset, including
estimates for finance charge yield, credit losses, LIBOR (which
determines future certificate interest costs), monthly payment
rate and discount rate. On a quarterly basis, the Company
compares the assumptions it uses in calculating the fair value of
its interest-only strip to observable market data when available,
and to historical trends. The interest-only strip is classified
within Level 3 of the fair value hierarchy due to the significance
of the unobservable inputs used in valuing this asset.
The following table presents the changes in fair value of the
Company’s retained subordinated securities and its interest-
only strip during the year ended December 31, 2008:
(Millions)
Investments-
Retained
Subordinated
Securities
Other
Assets-
Interest-
Only Strip
Beginning fair value $ 78 $ 223
Increases in securitized loans 1,250 71
Decreases in securitized loans — (42)
Total realized and unrealized losses (584)(a) (220)(b)
Ending fair value $ 744 $ 32
(a) Included in accumulated other comprehensive (loss) income.
(b) Included in securitization income, net.
Changes in the estimates and assumptions used may have a
significant impact on the Company’s valuation of the retained
interests. The key economic assumptions used in measuring
the interest-only strip asset at the time of issuance as well as
at December 31, 2008, and the sensitivity of the fair value to
immediate 10 percent and 20 percent adverse changes in these
assumptions are as follows (rates are per annum):
Interest-Only Strip
At time of issuance As of December 31, 2008
(Millions, except
rates per annum) 2008 2007 Assumptions
Impact on
fair value
of 10%
adverse
change(a)
Finance
charge
yield 13.5%-15.6% 15.8%-16.3% 13.8%-14.0% $(92.4)(b)
Expected
credit losses 4.3%-5.8% 2.6%-4.3% 9.2%-10.2% $(63.1)(b)
LIBOR 2.7%-4.6% 5.0%-5.4% 0.8%-2.0% $ (7.8)
Monthly
payment
rate 23.8%-24.7% 24.6%-25.6% 23.5% $ (0.2)
Discount
Rate 11.0%-12.0% 12.0% 19.4% $ (0.1)
(a) The impact on fair value of a 20 percent adverse change is approximately two
times the impact of a 10 percent adverse change identified above.
(b) The fair value of the interest-only strip is $32 million as of December 31, 2008.
Therefore, a 10 percent adverse change in the assumption would result in the
fair value of the interest-only strip written down to zero.
The key assumptions and the sensitivity of the current year’s
fair value of the retained subordinated securities to immediate
10 percent and 20 percent adverse changes in these key
assumptions are as follows:
Retained Subordinated Securities
(Millions, except
rates per annum) Assumptions
Impact on fair
value of 10%
adverse change
Impact on fair
value of 20%
adverse change
Discount rate 22.0%-32.6% $(45.0) $(85.4)
LIBOR 2.0%-2.5% $ (5.5) $(10.9)
This sensitivity analysis does not represent management’s
expectations of adverse changes in these assumptions but is
provided as a hypothetical scenario to assess the sensitivity of
the fair value of the retained subordinated interests to changes
in key inputs. Management cannot extrapolate changes in fair
value based on a 10 percent or 20 percent change in all key
assumptions simultaneously in part because the relationship of
the change in one assumption on the fair value of the retained
interest is calculated independently from any change in another
assumption. Changes in one factor may cause changes in
another, which could magnify or offset the sensitivities.