Wells Fargo 2010 Annual Report Download - page 90

Critical Accounting Policies (continued)
other assets. These nonrecurring fair value adjustments typically
involve application of lower-of-cost-or-market accounting or
write-downs of individual assets. Additionally, for financial
instruments not recorded at fair value we disclose the estimate of
their fair value.
Fair value represents the price that would be received to sell
the financial asset or paid to transfer the financial liability in an
orderly transaction between market participants at the
measurement date.
The accounting provisions for fair value measurements
include a three-level hierarchy for disclosure of assets and
liabilities recorded at fair value. The classification of assets and
liabilities within the hierarchy is based on whether the inputs to
the valuation methodology used for measurement are observable
or unobservable. Observable inputs reflect market-derived or
market-based information obtained from independent sources,
while unobservable inputs reflect our estimates about market
data.
• Level 1 – Valuation is based upon quoted prices for identical
instruments traded in active markets. Level 1 instruments
include securities traded on active exchange markets, such
as the New York Stock Exchange, as well as U.S. Treasury
and other U.S. government securities that are traded by
dealers or brokers in active OTC markets.
• Level 2 – Valuation is based upon quoted prices for similar
instruments in active markets, quoted prices for identical or
similar instruments in markets that are not active, and
model-based valuation techniques, such as matrix pricing,
for which all significant assumptions are observable in the
market. Level 2 instruments include securities traded in
functioning dealer or broker markets, plain-vanilla interest
rate derivatives and MHFS that are valued based on prices
for other mortgage whole loans with similar characteristics.
• Level 3 – Valuation is generated primarily from model-
based techniques that use significant assumptions not
observable in the market. These unobservable assumptions
reflect our own estimates of assumptions market
participants would use in pricing the asset or liability.
Valuation techniques include use of option pricing models,
discounted cash flow models and similar techniques.
When developing fair value measurements, we maximize the
use of observable inputs and minimize the use of unobservable
inputs. When available, we use quoted prices in active markets to
measure fair value. If quoted prices in active markets are not
available, fair value measurement is based upon models that use
primarily market-based or independently sourced market
parameters, including interest rate yield curves, prepayment
speeds, option volatilities and currency rates. However, in
certain cases, when market observable inputs for model-based
valuation techniques are not readily available, we are required to
make judgments about assumptions market participants would
use to estimate the fair value.
The degree of management judgment involved in determining
the fair value of a financial instrument is dependent upon the
availability of quoted prices in active markets or observable
market parameters. For financial instruments with quoted
market prices or observable market parameters in active
markets, there is minimal subjectivity involved in measuring fair
value. When quoted prices and observable data in active markets
are not fully available, management judgment is necessary to
estimate fair value. Changes in the market conditions, such as
reduced liquidity in the capital markets or changes in secondary
market activities, may reduce the availability and reliability of
quoted prices or observable data used to determine fair value.
When significant adjustments are required to price quotes or
inputs, it may be appropriate to utilize an estimate based
primarily on unobservable inputs. When an active market for a
financial instrument does not exist, the use of management
estimates that incorporate current market participant
expectations of future cash flows, adjusted for an appropriate
risk premium, is acceptable.
When markets for our financial assets and liabilities become
inactive because the level and volume of activity has declined
significantly relative to normal conditions, it may be appropriate
to adjust quoted prices. The methodology we use to adjust the
quoted prices generally involves weighting the quoted prices and
results of internal pricing techniques, such as the net present
value of future expected cash flows (with observable inputs,
where available) discounted at a rate of return market
participants require to arrive at the fair value. The more active
and orderly markets for particular security classes are
determined to be, the more weighting we assign to quoted prices.
The less active and orderly markets are determined to be, the less
weighting we assign to quoted prices.
We may use independent pricing services and brokers to
obtain fair values based on quoted prices. We determine the
most appropriate and relevant pricing service for each security
class and generally obtain one quoted price for each security. For
certain securities, we may use internal traders to obtain quoted
prices. Quoted prices are subject to our internal price verification
procedures. We validate prices received using a variety of
methods, including, but not limited to, comparison to pricing
services, corroboration of pricing by reference to other
independent market data such as secondary broker quotes and
relevant benchmark indices, and review of pricing by Company
personnel familiar with market liquidity and other market-
related conditions.
Significant judgment is also required to determine whether
certain assets measured at fair value are included in Level 2 or
Level 3. When making this judgment, we consider all available
information, including observable market data, indications of
market liquidity and orderliness, and our understanding of the
valuation techniques and significant inputs used. For securities
in inactive markets, we use a predetermined percentage to
evaluate the impact of fair value adjustments derived from
weighting both external and internal indications of value to
determine if the instrument is classified as Level 2 or Level 3.
Otherwise, the classification of Level 2 or Level 3 is based upon
the specific facts and circumstances of each instrument or
instrument category and judgments are made regarding the
significance of the Level 3 inputs to the instruments’ fair value
measurement in its entirety. If Level 3 inputs are considered
significant, the instrument is classified as Level 3.
Our financial assets valued using Level 3 measurements
consisted of certain asset-backed securities, including those
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