RBS 2010 Annual Report Download - page 321

For some instruments with a wide number of available price sources,
there may be differing quality of available information and there may be a
wide range of prices from different sources. In these situations an
assessment is made as to which source is the highest quality and this will
be used to determine the classification of the asset. For example, a
tradable quote would be considered a better source than a consensus
price.
Instruments that cross levels
Some instrumentswill predominantly be in one level or the other, but
others may cross between levels. For example, a cross currency swap
may be between very liquid currency pairs where pricing is readily
observed in the market and will therefore be classified as level 2. The
cross currency swap may also be between two illiquid currency pairs in
which case the swap would be placed into level 3. Defining the difference
between liquid and illiquid may be based upon the number of consensus
providers the consensus price is made up from and whether the
consensus price can be supplemented by other sources.
Certain portfolios in level 2 contain instruments whose fair values
incorporate the judgements discussed above. These include a portfolio of
ABS in Non-Core of £5.7 billion that had more than average level of
valuation uncertainty with a range of £5.6 billion to £5.9 billion using
alternative valuation assumptions.
Level 3 portfolios and sensitivity methodologies
For each of the portfolio categories shown in the tables above, there
follows a description of the types of products that comprise the portfolio
and the valuation techniques that are applied in determining fair value,
including a description of valuation techniques used for levels 2 and 3
and inputs to those models and techniques. Where reasonably possible
alternative assumptions of unobservable inputs used in models would
change the fair value of the portfolio significantly, the alternative inputs
are indicated. Where there have been significant changes to valuation
techniques during the year a discussion of the reasons for this are also
included.
Loans and advances to customers
Loans in level 3 primarilycomprise commercial mortgages.
Commercial mortgages
These senior andmezzanine commercial mortgages are loans secured
on commercial land and buildings that were originated or acquired by the
Group for securitisation. Senior commercial mortgages carry a variable
interest rate and mezzanine or more junior commercial mortgages may
carry a fixed or variable interest rate. Factors affecting the value of these
loans may include, but are not limited to, loan type, underlying property
type and geographic location, loan interest rate, loan to value ratios, debt
service coverage ratios, prepayment rates, cumulative loan loss
information, yields, investor demand, market volatility since the last
securitisation, and credit enhancement. Where observable market prices
for a particular loan are not available, the fair value will typically be
determined with reference to observable market transactions in other
loans or credit related products including debt securities and credit
derivatives. Assumptions are made about the relationship between the
loan and the available benchmark data.
Debt securities
RMBS
RMBS where the underlying assets are US agency-backed mortgages
and there is regular trading are generally classified as level 2 in the fair
value hierarchy. RMBS are also classified as level 2 when regular trading
is not prevalent in the market, but similar executed trades or third-party
data including indices, broker quotes and pricing services can be used to
substantiate the fair value. RMBS are classified as level 3 when trading
activity is not available and a model with significant unobservable data is
utilised.
In determining whether an instrument is similar to that being valued, the
Group considers a range of factors, principally: the lending standards of
the brokers and underwriters that originated the mortgages, the lead
manager of the security, the issue date of the respective securities, the
underlying asset composition (including origination date, loan to value
ratios, historic loss information and geographic location of the mortgages),
the credit rating of the instrument, and any credit protection that the
instrument may benefit from, such as insurance wraps or subordinated
tranches. Where there are instances of market observable data for
several similar RMBS tranches, the Group considers the extent of similar
characteristics shared with the instrument being valued, together with the
frequency, tenor and nature of the trades that have been observed. This
method is most frequently used for US and UK RMBS. RMBS of Dutch
and Spanish originated mortgages guaranteed by those governments are
valued using the credit spreads of the respective government debt and
certain assumptions made by the Group, or based on observable prices
from Bloomberg or consensus pricing services.
The Group primarily uses an industry standard model to project the
expected future cash flows to be received from the underlying mortgages
and to forecast how these cash flows will be distributed to the various
holders of the RMBS. This model utilises data provided by the servicer of
the underlying mortgage portfolio, layering on assumptions for mortgage
prepayments, probability of default, expected losses, and yield. The
Group uses data from third-party sources to calibrate its assumptions,
including pricing information from third-party pricing services,
independent research, broker quotes, and other independent sources. An
assessment is made of third-party data source to determine its
applicability and reliability. The Group adjusts the model price with a
liquidity premium to reflect the price that the instrument could be traded in
the market and may also make adjustments for model deficiencies.
The fair value of securities within each class of asset changes on a
broadly consistent basis in response to changes in given market factors.
However, the extent of the change, and therefore the range of reasonably
possible alternative assumptions, may be either more or less pronounced,
depending on the particular terms and circumstances of the individual
security. The Group believes that probability of default was the least
transparent input into Alt-A and prime RMBS modelled valuations (and
most sensitive to variations).
319RBS Group 2010
Financial statements