Bank of America 2013 Annual Report Download - page 117

Bank of America 2013 115
Fair Value of Financial Instruments
We classify the fair values of financial instruments based on the
fair value hierarchy established under applicable accounting
guidance which requires an entity to maximize the use of
observable inputs and minimize the use of unobservable inputs
when measuring fair value. Applicable accounting guidance
establishes three levels of inputs used to measure fair value. We
carry trading account assets and liabilities, derivative assets and
liabilities, AFS debt and equity securities, other debt securities
carried at fair value, certain MSRs and certain other assets at fair
value. Also, we account for certain loans and loan commitments,
LHFS, short-term borrowings, securities financing agreements,
asset-backed secured financings, long-term deposits and long-
term debt under the fair value option. For additional information,
see Note 20 – Fair Value Measurements and Note 21 – Fair Value
Option to the Consolidated Financial Statements.
The fair values of assets and liabilities may include
adjustments, such as market liquidity and credit quality, where
appropriate. Valuations of products using models or other
techniques are sensitive to assumptions used for the significant
inputs. Where market data is available, the inputs used for
valuation reflect that information as of our valuation date. Inputs
to valuation models are considered unobservable if they are
supported by little or no market activity. In periods of extreme
volatility, lessened liquidity or in illiquid markets, there may be
more variability in market pricing or a lack of market data to use
in the valuation process. In keeping with the prudent application
of estimates and management judgment in determining the fair
value of assets and liabilities, we have in place various processes
and controls that include: a model validation policy that requires
review and approval of quantitative models used for deal pricing,
financial statement fair value determination and risk
quantification; a trading product valuation policy that requires
verification of all traded product valuations; and a periodic review
and substantiation of daily profit and loss reporting for all traded
products. Primarily through validation controls, we utilize both
broker and pricing service inputs which can and do include both
market-observable and internally-modeled values and/or valuation
inputs. Our reliance on this information is tempered by the
knowledge of how the broker and/or pricing service develops its
data with a higher degree of reliance applied to those that are
more directly observable and lesser reliance applied to those
developed through their own internal modeling. Similarly, broker
quotes that are executable are given a higher level of reliance than
indicative broker quotes, which are not executable. These
processes and controls are performed independently of the
business.
Trading account assets and liabilities are carried at fair value
based primarily on actively traded markets where prices are based
on either direct market quotes or observed transactions. Liquidity
is a significant factor in the determination of the fair values of
trading account assets and liabilities. Market price quotes may
not be readily available for some positions, or positions within a
market sector where trading activity has slowed significantly or
ceased. Situations of illiquidity generally are triggered by the
market’s perception of credit uncertainty regarding a single
company or a specific market sector. In these instances, fair value
is determined based on limited available market information and
other factors, principally from reviewing the issuer’s financial
statements and changes in credit ratings made by one or more
rating agencies.
Trading account profits, which represent the net amount earned
from our trading positions, can be volatile and are largely driven
by general market conditions and customer demand. Trading
account profits are dependent on the volume and type of
transactions, the level of risk assumed, and the volatility of price
and rate movements at any given time within the ever-changing
market environment. To evaluate risk in our trading activities, we
focus on the actual and potential volatility of individual positions
as well as portfolios. At a portfolio and corporate level, we use
trading limits, stress testing and tools such as VaR modeling, which
estimates a potential daily loss that we do not expect to exceed
with a specified confidence level, to measure and manage market
risk. For more information on VaR, see Trading Risk Management
on page 105.
The fair values of derivative assets and liabilities traded in the
OTC market are determined using quantitative models that utilize
multiple market inputs including interest rates, prices and indices
to generate continuous yield or pricing curves and volatility factors
to value the position. The majority of market inputs are actively
quoted and can be validated through external sources, including
brokers, market transactions and third-party pricing services.
Estimation risk is greater for derivative asset and liability positions
that are either option-based or have longer maturity dates where
observable market inputs are less readily available, or are
unobservable, in which case, quantitative-based extrapolations of
rate, price or index scenarios are used in determining fair values.
The fair values of derivative assets and liabilities include
adjustments for market liquidity, counterparty credit quality and
other instrument-specific factors, where appropriate. In addition,
the Corporation incorporates within its fair value measurements
of OTC derivatives a valuation adjustment to reflect the credit risk
associated with the net position. Positions are netted by
counterparty, and fair value for net long exposures is adjusted for
counterparty credit risk while the fair value for net short exposures
is adjusted for our own credit risk. An estimate of severity of loss
is also used in the determination of fair value, primarily based on
market data. We do not incorporate a funding valuation or funding
benefit adjustment (collectively, FVA) into the fair value of our
uncollateralized derivatives. There is diversity in industry practice
regarding FVA and such views continue to evolve. We continue to
evaluate FVA as it relates to our valuation methodologies used to
comply with applicable fair value accounting guidance.