27. FAIR VALUE MEASUREMENTS
The Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S. GAAP also establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument's fair value measurement. For more information regarding the fair value hierarchy and how the Bancorp measures fair value, see Note 1.
| Assets and Liabilities Measured at Fair Value on a Recurring Basis | |||||
| The following tables summarize assets and liabilities measured at fair value on a recurring basis, including residential mortgage loans held for sale for which the Bancorp has elected the fair value option as of: | |||||
| Fair Value Measurements Using | |||||
| December 31, 2013 ($ in millions) | Level 1(c) | Level 2(c) | Level 3 | Total Fair Value | |
| Assets: | |||||
| Available-for-sale securities: | |||||
| U.S. Treasury and Government agencies | $ | 26 | - | - | 26 |
| U.S. Government sponsored agencies | - | 1,644 | - | 1,644 | |
| Obligations of states and political subdivisions | - | 192 | - | 192 | |
| Agency mortgage-backed securities | - | 12,284 | - | 12,284 | |
| Other bonds, notes and debentures | - | 3,582 | - | 3,582 | |
| Other securities(a) | 89 | 29 | - | 118 | |
| Available-for-sale securities(a) | 115 | 17,731 | - | 17,846 | |
| Trading securities: | |||||
| U.S. Treasury and Government agencies | 1 | - | - | 1 | |
| U.S. Government sponsored agencies | - | 4 | - | 4 | |
| Obligations of states and political subdivisions | - | 12 | 1 | 13 | |
| Agency mortgage-backed securities | - | 3 | - | 3 | |
| Other bonds, notes and debentures | - | 7 | - | 7 | |
| Other securities | 315 | - | - | 315 | |
| Trading securities | 316 | 26 | 1 | 343 | |
| Residential mortgage loans held for sale | - | 890 | - | 890 | |
| Residential mortgage loans(b) | - | - | 92 | 92 | |
| Derivative assets: | |||||
| Interest rate contracts | 13 | 802 | 12 | 827 | |
| Foreign exchange contracts | - | 276 | - | 276 | |
| Equity contracts | - | - | 384 | 384 | |
| Commodity contracts | 18 | 48 | - | 66 | |
| Derivative assets | 31 | 1,126 | 396 | 1,553 | |
| Total assets | $ | 462 | 19,773 | 489 | 20,724 |
| Liabilities: | |||||
| Derivative liabilities: | |||||
| Interest rate contracts | $ | 1 | 384 | 4 | 389 |
| Foreign exchange contracts | - | 252 | - | 252 | |
| Equity contracts | - | - | 48 | 48 | |
| Commodity contracts | 9 | 56 | - | 65 | |
| Derivative liabilities | 10 | 692 | 52 | 754 | |
| Short positions | 4 | 4 | - | 8 | |
| Total liabilities | $ | 14 | 696 | 52 | 762 |
| Fair Value Measurements Using | |||||
| December 31, 2012 ($ in millions) | Level 1(c) | Level 2(c) | Level 3 | Total Fair Value | |
| Assets: | |||||
| Available-for-sale securities: | |||||
| U.S. Treasury and Government agencies | $ | 41 | - | - | 41 |
| U.S. Government sponsored agencies | - | 1,911 | - | 1,911 | |
| Obligations of states and political subdivisions | - | 212 | - | 212 | |
| Agency mortgage-backed securities | - | 8,730 | - | 8,730 | |
| Other bonds, notes and debentures | - | 3,277 | - | 3,277 | |
| Other securities(a) | 79 | 113 | - | 192 | |
| Available-for-sale securities(a) | 120 | 14,243 | - | 14,363 | |
| Trading securities: | |||||
| U.S. Treasury and Government agencies | 1 | - | - | 1 | |
| U.S. Government sponsored agencies | - | 6 | - | 6 | |
| Obligations of states and political subdivisions | - | 16 | 1 | 17 | |
| Agency mortgage-backed securities | - | 7 | - | 7 | |
| Other bonds, notes and debentures | - | 15 | - | 15 | |
| Other securities | 161 | - | - | 161 | |
| Trading securities | 162 | 44 | 1 | 207 | |
| Residential mortgage loans held for sale | - | 2,856 | - | 2,856 | |
| Residential mortgage loans(b) | - | - | 76 | 76 | |
| Derivative assets: | |||||
| Interest rate contracts | 2 | 1,445 | 60 | 1,507 | |
| Foreign exchange contracts | - | 201 | - | 201 | |
| Equity contracts | - | - | 177 | 177 | |
| Commodity contracts | - | 87 | - | 87 | |
| Derivative assets | 2 | 1,733 | 237 | 1,972 | |
| Total assets | $ | 284 | 18,876 | 314 | 19,474 |
| Liabilities: | |||||
| Derivative liabilities: | |||||
| Interest rate contracts | $ | 14 | 600 | 3 | 617 |
| Foreign exchange contracts | - | 183 | - | 183 | |
| Equity contracts | - | - | 33 | 33 | |
| Commodity contracts | - | 82 | - | 82 | |
| Derivative liabilities | 14 | 865 | 36 | 915 | |
| Short positions | 8 | 2 | - | 10 | |
| Total liabilities | $ | 22 | 867 | 36 | 925 |
The following is a description of the valuation methodologies used for significant instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Available-for-sale and trading securities
Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include government bonds and exchange traded equities. If quoted market prices are not available, then fair values are estimated using quoted prices of securities with similar characteristics, or pricing models, such as discounted cash flows. Examples of such instruments, which are classified within Level 2 of the valuation hierarchy, include agency and non-agency mortgage-backed securities, other asset-backed securities, obligations of U.S. Government sponsored agencies, and corporate and municipal bonds. Corporate bonds are included in other bonds, notes and debentures in the previous table. Agency mortgage-backed securities, obligations of U.S. Government sponsored agencies, and corporate and municipal bonds are generally valued using a market approach based on observable prices of securities with similar characteristics.
Residential mortgage loans held for sale
For residential mortgage loans held for sale, fair value is estimated based upon mortgage-backed securities prices and spreads to those prices or, for certain ARM loans, DCF models that may incorporate the anticipated portfolio composition, credit spreads of asset-backed securities with similar collateral and market conditions. The anticipated portfolio composition includes the effect of interest rate spreads and discount rates due to loan characteristics such as the state in which the loan was originated, the loan amount and the ARM margin. Residential mortgage loans held for sale that are valued based on mortgage backed securities prices are classified within Level 2 of the valuation hierarchy as the valuation is based on external pricing for similar instruments. ARM loans classified as held for sale are also classified within Level 2 of the valuation hierarchy due to the use of observable inputs in the DCF model. These observable inputs include interest rate spreads from agency mortgage-backed securities market rates and observable discount rates.
Residential mortgage loans
Residential mortgage loans held for sale that are reclassified to held for investment are transferred from Level 2 to Level 3 of the fair value hierarchy. It is the Bancorp's policy to value any transfers between levels of the fair value hierarchy based on end of period fair values.
For residential mortgage loans reclassified from held for sale to held for investment, the fair value estimation is based on mortgage-backed securities prices, interest rate risk and an internally developed credit component. Therefore, these loans are classified within Level 3 of the valuation hierarchy. An adverse change in the loss rate or severity assumption would result in a decrease in fair value of the related loan. The Secondary Marketing Department, which reports to the Bancorp's Chief Operating Officer, in conjunction with the Consumer Credit Risk Department, which reports to the Bancorp's Chief Risk and Credit Officer, are responsible for determining the valuation methodology for residential mortgage loans held for investment. The Secondary Marketing Department reviews loss severity assumptions quarterly to determine if adjustments are necessary based on decreases in observable housing market data. This group also reviews trades in comparable benchmark securities and adjusts the values of loans as necessary. Consumer Credit Risk is responsible for the credit component of the fair value which is based on internally developed loss rate models that take into account historical loss rates and loss severities based on underlying collateral values.
Derivatives
Exchange-traded derivatives valued using quoted prices and certain over-the-counter derivatives valued using active bids are classified within Level 1 of the valuation hierarchy. Most of the Bancorp's derivative contracts are valued using discounted cash flow or other models that incorporate current market interest rates, credit spreads assigned to the derivative counterparties and other market parameters and, therefore, are classified within Level 2 of the valuation hierarchy. Such derivatives include basic and structured interest rate swaps and options. Derivatives that are valued based upon models with significant unobservable market parameters are classified within Level 3 of the valuation hierarchy. At December 31, 2013 and 2012, derivatives classified as Level 3, which are valued using models containing unobservable inputs, consisted primarily of a warrant associated with the initial sale of the Bancorp's 51% interest in Vantiv Holding, LLC to Advent International and a total return swap associated with the Bancorp's sale of Visa, Inc. Class B shares. Level 3 derivatives also include interest rate lock commitments, which utilize internally generated loan closing rate assumptions as a significant unobservable input in the valuation process.
The warrant allows the Bancorp to purchase approximately 20 million incremental nonvoting units in Vantiv Holding, LLC under certain defined conditions involving change of control. The fair value of the warrant is calculated in conjunction with a third party valuation provider by applying Black-Scholes option valuation models using probability weighted scenarios which contain the following inputs: Vantiv, Inc. stock price, strike price per the Warrant Agreement and several unobservable inputs, such as expected term, expected volatility, and expected dividend rate.
For the warrant, an increase in the expected term (years) and the expected volatility assumptions would result in an increase in the fair value; correspondingly, a decrease in these assumptions would result in a decrease in the fair value. The Accounting and Treasury Departments, both of which report to the Bancorp's Chief Financial Officer, determined the valuation methodology for the warrant. Accounting and Treasury review changes in fair value on a quarterly basis for reasonableness based on changes in historical and implied volatilities, expected terms, probability weightings of the related scenarios, and other assumptions.
Under the terms of the total return swap, the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Visa, Inc. Class B shares into Class A shares. Additionally, the Bancorp will make a quarterly payment based on Visa's stock price and the conversion rate of the Visa, Inc. Class B shares into Class A shares until the date on which the Covered Litigation is settled. The fair value of the total return swap was calculated using a discounted cash flow model based on unobservable inputs consisting of management's estimate of the probability of certain litigation scenarios, the timing of the resolution of the Covered Litigation and Visa litigation loss estimates in excess, or shortfall, of the Bancorp's proportional share of escrow funds.
An increase in the loss estimate or a delay in the resolution of the Covered Litigation would result in an increase in fair value; correspondingly, a decrease in the loss estimate or an acceleration of the resolution of the Covered Litigation would result in a decrease in fair value. The Accounting and Treasury Departments determined the valuation methodology for the total return swap. Accounting and Treasury review the changes in fair value on a quarterly basis for reasonableness based on Visa stock price changes, litigation contingencies, and escrow funding.
The net fair value asset of the interest rate lock commitments at December 31, 2013 was $11 million. Immediate decreases in current interest rates of 25 bps and 50 bps would result in increases in the fair value of the interest rate lock commitments of approximately $8 million and $15 million, respectively. Immediate increases of current interest rates of 25 bps and 50 bps would result in decreases in the fair value of the interest rate lock commitments of approximately $9 million and $18 million, respectively. The decrease in fair value of interest rate lock commitments due to immediate 10% and 20% adverse changes in the assumed loan closing rates would be approximately $1 million and $2 million, respectively, and the increase in fair value due to immediate 10% and 20% favorable changes in the assumed loan closing rates would be approximately $1 million and $2 million, respectively. These sensitivities are hypothetical and should be used with caution, as changes in fair value based on a variation in assumptions typically cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear.
The Secondary Marketing Department and the Consumer Line of Business Finance Department, which reports to the Bancorp's Chief Financial Officer, are responsible for determining the valuation methodology for IRLCs. Secondary Marketing, in conjunction with a third party valuation provider, periodically review loan closing rate assumptions and recent loan sales to determine if adjustments are needed for current market conditions not reflected in historical data.
| The following tables are a reconciliation of assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3): | ||||||||
| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) | ||||||||
| Residential | Interest Rate | Equity | ||||||
| For the year ended December 31, 2013 | Trading | Mortgage | Derivatives, | Derivatives, | Total | |||
| ($ in millions) | Securities | Loans | Net(a) | Net(a) | Fair Value | |||
| Beginning balance | $ | 1 | 76 | 57 | 144 | $ | 278 | |
| Total gains or losses (realized/unrealized): | ||||||||
| Included in earnings | - | (1) | 59 | 175 | 233 | |||
| Purchases | - | - | (2) | - | (2) | |||
| Settlements | - | (17) | (106) | 17 | (106) | |||
| Transfers into Level 3(b) | - | 34 | - | - | 34 | |||
| Ending balance | $ | 1 | 92 | 8 | 336 | $ | 437 | |
| The amount of total gains (losses) for the period | ||||||||
| included in earnings attributable to the change in | ||||||||
| unrealized gains or losses relating to assets | ||||||||
| still held at December 31, 2013(c) | $ | - | (1) | 11 | 175 | $ | 185 | |
| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) | ||||||||||
| Residential | Interest Rate | Equity | ||||||||
| For the year ended December 31, 2012 | Trading | Mortgage | Derivatives, | Derivatives, | Total | |||||
| ($ in millions) | Securities | Loans | Net(a) | Net(a) | Fair Value | |||||
| Beginning balance | $ | 1 | 65 | 32 | 32 | $ | 130 | |||
| Total gains or losses (realized/unrealized): | ||||||||||
| Included in earnings | - | - | 418 | 22 | 440 | |||||
| Settlements | - | (15) | (393) | 90 | (318) | |||||
| Transfers into Level 3(b) | - | 26 | - | - | 26 | |||||
| Ending balance | $ | 1 | 76 | 57 | 144 | $ | 278 | |||
| The amount of total gains (losses) for the period | ||||||||||
| included in earnings attributable to the change in | ||||||||||
| unrealized gains or losses relating to assets | ||||||||||
| still held at December 31, 2012(c) | $ | - | - | 233 | 22 | $ | 255 | |||
| Fair Value Measurements Using Significant Unobservable Inputs (Level 3) | ||||||||
| Residential | Interest Rate | Equity | ||||||
| For the year ended December 31, 2011 | Trading | Mortgage | Derivatives, | Derivatives, | Total | |||
| ($ in millions) | Securities | Loans | Net(a) | Net(a) | Fair Value | |||
| Beginning balance | $ | 6 | 46 | 2 | 53 | $ | 107 | |
| Total gains or losses (realized/unrealized): | ||||||||
| Included in earnings | - | 4 | 205 | (43) | 166 | |||
| Purchases | - | - | - | 2 | 2 | |||
| Sales | (5) | - | - | - | (5) | |||
| Settlements | - | (9) | (175) | 20 | (164) | |||
| Transfers into Level 3(b) | - | 24 | - | - | 24 | |||
| Ending balance | $ | 1 | 65 | 32 | 32 | $ | 130 | |
| The amount of total gains (losses) for the period | ||||||||
| included in earnings attributable to the change in | ||||||||
| unrealized gains or losses relating to assets | ||||||||
| still held at December 31, 2011(c) | $ | - | 4 | 32 | (43) | $ | (7) | |
| The total gains and losses included in earnings for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) were recorded in the Consolidated Statements of Income as follows: | |||||||
| ($ in millions) | 2013 | 2012 | 2011 | ||||
| Mortgage banking net revenue | 57 | 418 | 210 | ||||
| Corporate banking revenue | 1 | 1 | 2 | ||||
| Other noninterest income | 175 | 21 | (46) | ||||
| Total gains | $ | 233 | 440 | 166 | |||
| The total gains and losses included in earnings attributable to changes in unrealized gains and losses related to Level 3 assets and liabilities still held at December 31, 2013, 2012 and 2011 were recorded in the Consolidated Statements of Income as follows: | |||||||
| ($ in millions) | 2013 | 2012 | 2011 | ||||
| Mortgage banking net revenue | 10 | 233 | 37 | ||||
| Corporate banking revenue | - | 1 | 1 | ||||
| Other noninterest income | 175 | 21 | (45) | ||||
| Total (losses) gains | $ | 185 | 255 | (7) | |||
| The following table presents information as of December 31, 2013 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured on a recurring basis: | ||||||
| ($ in millions) | ||||||
| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges of Inputs | Weighted-Average | |
| Residential mortgage loans | $ | 92 | Loss rate model | Interest rate risk factor | (23.7) - 16.5% | 2.3% |
| Credit risk factor | 0 - 63.4% | 2.6% | ||||
| IRLCs, net | 11 | Discounted cash flow | Loan closing rates | 14.9 - 98.7% | 68.5% | |
| Stock warrant associated with Vantiv Holding, LLC | 384 | Black-Scholes option | Expected term (years) | 2.00 - 15.50 | 5.1 | |
| valuation model | Expected volatility(a) | 18.5 - 33.2% | 25.4% | |||
| Expected dividend rate | - | - | ||||
| Swap associated with the sale of Visa, Inc. | (48) | Discounted cash flow | Timing of the resolution | 12/31/2014 - | NM | |
| Class B shares | of the Covered Litigation | 12/31/2019 | ||||
| The following table presents information as of December 31, 2012 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured on a recurring basis: | ||||||
| ($ in millions) | ||||||
| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges of Inputs | Weighted-Average | |
| Residential mortgage loans | $ | 76 | Loss rate model | Interest rate risk factor | (91.2) - 17.0% | 5.8% |
| Credit risk factor | 0 - 68.4% | 4.3% | ||||
| IRLCs, net | 60 | Discounted cash flow | Loan closing rates | 9.9 - 95.0% | 58.3% | |
| Stock warrant associated with Vantiv Holding, LLC | 177 | Black-Scholes option | Expected term (years) | 2.00 - 16.50 | 6.2 | |
| valuation model | Expected volatility(a) | 27.2 - 40.0% | 33.8% | |||
| Expected dividend rate | - | - | ||||
| Swap associated with the sale of Visa, Inc. | (33) | Discounted cash flow | Timing of the resolution | 12/31/2013 - | NM | |
| Class B shares | of the Covered Litigation | 12/31/2016 | ||||
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
Certain assets and liabilities are measured at fair value on a nonrecurring basis. These assets and liabilities are not measured at fair value on an ongoing basis; however, they are subject to fair value adjustments in certain circumstances, such as when there is evidence of impairment.
| The following tables represent those assets that were subject to fair value adjustments during the years ended December 31, 2013 and 2012 and still held as of the end of the period, and the related losses from fair value adjustments on assets sold during the period as well as assets still held as of the end of the period: | |||||||||||
| Fair Value Measurements Using | Total Losses | ||||||||||
| As of December 31, 2013 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | 2013 | ||||||
| Commercial loans held for sale(a) | $ | - | - | 3 | 3 | (7) | |||||
| Commercial and industrial loans | - | - | 443 | 443 | (281) | ||||||
| Commercial mortgage loans | - | - | 61 | 61 | (41) | ||||||
| Commercial construction loans | - | - | 16 | 16 | (10) | ||||||
| MSRs | - | - | 967 | 967 | 192 | ||||||
| OREO | - | - | 87 | 87 | (45) | ||||||
| Private equity investment funds | - | - | 181 | 181 | (4) | ||||||
| Total | $ | - | - | 1,758 | 1,758 | (196) | |||||
| Fair Value Measurements Using | Total Losses | ||||||||||
| As of December 31, 2012 ($ in millions) | Level 1 | Level 2 | Level 3 | Total | 2012 | ||||||
| Commercial loans held for sale(a) | $ | - | - | 9 | 9 | (13) | |||||
| Commercial and industrial loans | - | - | 83 | 83 | (122) | ||||||
| Commercial mortgage loans | - | - | 46 | 46 | (50) | ||||||
| Commercial construction loans | - | - | 4 | 4 | (22) | ||||||
| MSRs | - | - | 697 | 697 | (103) | ||||||
| OREO | - | - | 165 | 165 | (74) | ||||||
| Total | $ | - | - | 1,004 | 1,004 | (384) | |||||
| The following tables present information as of December 31, 2013 and 2012 about significant unobservable inputs related to the Bancorp’s material categories of Level 3 financial assets and liabilities measured on a nonrecurring basis: | ||||||
| As of December 31, 2013 ($ in millions) | ||||||
| Financial Instrument | Fair Value | Valuation Technique | Significant Unobservable Inputs | Ranges of Inputs | Weighted-Average | |
| Commercial loans held for sale | $ | 3 | Appraised value | Appraised value | NM | NM |
| Cost to sell | NM | 10.0% | ||||
| Commercial and industrial loans | 443 | Appraised value | Collateral value | NM | NM | |
| Commercial mortgage loans | 61 | Appraised value | Collateral value | NM | NM | |
| Commercial construction loans | 16 | Appraised value | Collateral value | NM | NM | |
| MSRs | 967 | Discounted cash flow | Prepayment speed | 0 - 100% | (Fixed) 10.3% (Adjustable) 25.6% | |
| Discount rates | 9.4 - 18.0% | (Fixed) 10.4% (Adjustable) 11.6% | ||||
| OREO | 87 | Appraised value | Appraised value | NM | NM | |
| Private equity investment funds | 44(a) | Liquidity discount applied to fund's net asset value | Liquidity discount | 0 - 18% | 3.0% | |
| As of December 31, 2012 ($ in millions) | ||||||
| Significant Unobservable | Ranges of | |||||
| Financial Instrument | Fair Value | Valuation Technique | Inputs | Inputs | Weighted-Average | |
| Commercial loans held for sale | $ | 9 | Appraised value | Appraised value | NM | NM |
| Cost to sell | NM | 10.0% | ||||
| Commercial and industrial loans | 83 | Appraised value | Default rates | 100% | NM | |
| Collateral value | NM | NM | ||||
| Commercial mortgage loans | 46 | Appraised value | Default rates | 100% | NM | |
| Collateral value | NM | NM | ||||
| Commercial construction loans | 4 | Appraised value | Default rates | 100% | NM | |
| Collateral value | NM | NM | ||||
| MSRs | 697 | Discounted cash flow | Prepayment speed | 0 - 100% | (Fixed) 16.1% (Adjustable) 26.9% | |
| Discount rates | 9.4 - 18.0% | (Fixed) 10.5% (Adjustable) 11.7% | ||||
| OREO | 165 | Appraised value | Appraised value | NM | NM | |
Commercial loans held for sale
During 2013 and 2012, the Bancorp transferred $5 million and $16 million, respectively, of commercial loans from the portfolio to loans held for sale that upon transfer were measured at fair value using significant unobservable inputs. These loans had fair value adjustments in 2013 and 2012 totaling $4 million and $1 million, respectively, and were generally based on appraisals of the underlying collateral and were therefore, classified within Level 3 of the valuation hierarchy. Additionally, during 2013 and 2012 there were fair value adjustments on existing commercial loans held for sale of $3 million and $12 million, respectively. The fair value adjustments were also based on appraisals of the underlying collateral and were therefore classified within Level 3 of the valuation hierarchy. An adverse change in the fair value of the underlying collateral would result in a decrease in the fair value measurement. The Accounting Department determines the procedures for valuation of commercial HFS loans which may include a comparison to recently executed transactions of similar type loans. A monthly review of the portfolio is performed for reasonableness. Quarterly, appraisals approaching a year old are updated and the Real Estate Valuation group, which reports to the Chief Risk and Credit Officer, in conjunction with the Commercial Line of Business review the third party appraisals for reasonableness. Additionally, the Commercial Line of Business Finance Department, which reports to the Bancorp Chief Financial Officer, in conjunction with Accounting review all loan appraisal values, carrying values and vintages.
Commercial loans held for investment
During 2013 and 2012, the Bancorp recorded nonrecurring impairment adjustments to certain commercial and industrial, commercial mortgage and commercial construction loans held for investment. Larger commercial loans included within aggregate borrower relationship balances exceeding $1 million that exhibit probable or observed credit weaknesses are subject to individual review for impairment. The Bancorp considers the current value of collateral, credit quality of any guarantees, the guarantor's liquidity and willingness to cooperate, the loan structure and other factors when evaluating whether an individual loan is impaired. When the loan is collateral dependent, the fair value of the loan is generally based on the fair value of the underlying collateral supporting the loan and therefore these loans were classified within Level 3 of the valuation hierarchy. In cases where the carrying value exceeds the fair value, an impairment loss is recognized.
An adverse change in the fair value of the underlying collateral would result in a decrease in the fair value measurement. The fair values and recognized impairment losses are reflected in the previous table. Commercial Credit Risk, which reports to the Chief Risk and Credit Officer, is responsible for preparing and reviewing the fair value estimates for commercial loans held for investment.
MSRs
Mortgage interest rates increased during the year ended December 31, 2013 and the Bancorp recognized a recovery of temporary impairment on servicing rights. The Bancorp recognized temporary impairments in certain classes of the MSR portfolio during the year ended December 31, 2012 and the carrying value was adjusted to the fair value. MSRs do not trade in an active, open market with readily observable prices. While sales of MSRs do occur, the precise terms and conditions typically are not readily available. Accordingly, the Bancorp estimates the fair value of MSRs using internal discounted cash flow models with certain unobservable inputs, primarily prepayment speed assumptions, discount rates and weighted average lives, resulting in a classification within Level 3 of the valuation hierarchy. Refer to Note 11 for further information on the assumptions used in the valuation of the Bancorp's MSRs. The Secondary Marketing Department and Treasury Department are responsible for determining the valuation methodology for MSRs. Representatives from Secondary Marketing, Treasury, Accounting and Risk Management are responsible for reviewing key assumptions used in the internal discounted cash flow model. Two external valuations of the MSR portfolio are obtained from third parties that use valuation models in order to assess the reasonableness of the internal discounted cash flow model. Additionally, the Bancorp participates in peer surveys that provide additional confirmation of the reasonableness of key assumptions utilized in the MSR valuation process and the resulting MSR prices.
OREO
During 2013 and 2012, the Bancorp recorded nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO and measured at the lower of carrying amount or fair value. These nonrecurring losses are primarily due to declines in real estate values of the properties recorded in OREO. For the years ended December 31, 2013 and 2012, these losses include $19 million and $17 million, respectively, recorded as charge-offs, on new OREO properties transferred from loans during the respective periods and $26 million and $57 million, respectively, recorded as negative fair value adjustments on OREO in other noninterest income subsequent to their transfer from loans. As discussed in the following paragraphs, the fair value amounts are generally based on appraisals of the property values, resulting in a classification within Level 3 of the valuation hierarchy. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized. The previous tables reflect the fair value measurements of the properties before deducting the estimated costs to sell.
The Real Estate Valuation department, which reports to the Chief Risk and Credit Officer, is solely responsible for managing the appraisal process and evaluating the appraisal for all commercial properties transferred to OREO. All appraisals on commercial OREO properties are updated on at least an annual basis.
The Real Estate Valuation department reviews the BPO data and internal market information to determine the initial charge-off on residential real estate loans transferred to OREO. Once the foreclosure process is completed, the Bancorp performs an interior inspection to update the initial fair value of the property. These properties are reviewed at least every 30 days after the initial interior inspections are completed. The Asset Manager receives a monthly status report for each property which includes the number of showings, recently sold properties, current comparable listings and overall market conditions.
Private equity investment funds
The Volcker Rule, which was approved by the respective federal agencies on December 10, 2013 and becomes effective July 21, 2015, prohibits the Bancorp from retaining an interest in certain of its private equity fund investments. Therefore, while the Bancorp has not approved a formal plan to sell any of the private equity funds, the Bancorp has determined that it may be forced to sell certain of these funds prior to their scheduled redemption dates. As a result, the Bancorp has performed nonrecurring fair value measurements on a fund by fund basis to determine whether OTTI exists. The Bancorp estimated the fair value of a fund by using the net asset value reported by the fund manager, and in some cases, applying an estimated market discount to the reported net asset value of the fund. Because the length of time until the investment will become redeemable is generally not certain, these funds were classified within Level 3 of the valuation hierarchy. An adverse change in the reported net asset values or estimated market discounts where applicable, would result in a decrease in the fair value estimate. In cases where the carrying value exceeds the fair value, an impairment loss is recognized. The Bancorp's private equity department, which reports to the Chief Operating Officer, in conjunction with Accounting, is responsible for preparing and reviewing the fair value estimates.
Fair Value Option
The Bancorp elected to measure certain residential mortgage loans held for sale under the fair value option as allowed under U.S. GAAP. Electing to measure residential mortgage loans held for sale at fair value reduces certain timing differences and better matches changes in the value of these assets with changes in the value of derivatives used as economic hedges for these assets. Management's intent to sell residential mortgage loans classified as held for sale may change over time due to such factors as changes in the overall liquidity in markets or changes in characteristics specific to certain loans held for sale. Consequently, these loans may be reclassified to loans held for investment and maintained in the Bancorp's loan portfolio. In such cases, the loans will continue to be measured at fair value.
Fair value changes recognized in earnings for instruments held at December 31, 2013 and 2012 for which the fair value option was elected as well as the changes in fair value of the underlying IRLCs, included gains of $20 million and $157 million, respectively. Additionally, fair value changes included in earnings for instruments for which the fair value option was elected but are no longer held by the Bancorp at December 31, 2013 and 2012 included gains of $431 million and $849 million during 2013 and 2012, respectively. These gains are reported in mortgage banking net revenue in the Consolidated Statements of Income.
Valuation adjustments related to instrument-specific credit risk for residential mortgage loans measured at fair value negatively impacted the fair value of those loans by $2 million and $3 million at December 31, 2013 and 2012, respectively. Interest on residential mortgage loans measured at fair value is accrued as it is earned using the effective interest method and is reported as interest income in the Consolidated Statements of Income.
| The following table summarizes the difference between the fair value and the principal balance for residential mortgage loans measured at fair value as of: | |||||
| Aggregate | Aggregate Unpaid | ||||
| ($ in millions) | Fair Value | Principal Balance | Difference | ||
| December 31, 2013 | |||||
| Residential mortgage loans measured at fair value | $ | 982 | 962 | 20 | |
| Past due loans of 90 days or more | 1 | 2 | (1) | ||
| Nonaccrual loans | 2 | 2 | - | ||
| December 31, 2012 | |||||
| Residential mortgage loans measured at fair value | $ | 2,932 | 2,775 | 157 | |
| Past due loans of 90 days or more | 3 | 4 | (1) | ||
| Nonaccrual loans | - | 1 | (1) | ||
Fair Value of Certain Financial Instruments
| The following tables summarize the carrying amounts and estimated fair values for certain financial instruments, excluding financial instruments measured at fair value on a recurring basis: | ||||||
| Net Carrying | Fair Value Measurements Using | Total | ||||
| As of December 31, 2013 ($ in millions) | Amount | Level 1 | Level 2 | Level 3 | Fair Value | |
| Financial assets: | ||||||
| Cash and due from banks | $ | 3,178 | 3,178 | - | - | 3,178 |
| Other securities | 751 | - | 751 | - | 751 | |
| Held-to-maturity securities | 208 | - | - | 208 | 208 | |
| Other short-term investments | 5,116 | 5,116 | - | - | 5,116 | |
| Loans held for sale | 54 | - | - | 54 | 54 | |
| Portfolio loans and leases: | ||||||
| Commercial and industrial loans | 38,549 | - | - | 39,804 | 39,804 | |
| Commercial mortgage loans | 7,854 | - | - | 7,430 | 7,430 | |
| Commercial construction loans | 1,013 | - | - | 856 | 856 | |
| Commercial leases | 3,572 | - | - | 3,261 | 3,261 | |
| Residential mortgage loans(a) | 12,399 | - | - | 11,541 | 11,541 | |
| Home equity | 9,152 | - | - | 9,181 | 9,181 | |
| Automobile loans | 11,961 | - | - | 11,748 | 11,748 | |
| Credit card | 2,202 | - | - | 2,380 | 2,380 | |
| Other consumer loans and leases | 348 | - | - | 361 | 361 | |
| Unallocated allowance for loan and lease losses | (110) | - | - | - | - | |
| Total portfolio loans and leases, net(a) | 86,940 | - | - | 86,562 | 86,562 | |
| Financial liabilities: | ||||||
| Deposits | 99,275 | - | 99,288 | - | 99,288 | |
| Federal funds purchased | 284 | 284 | - | - | 284 | |
| Other short-term borrowings | 1,380 | - | 1,380 | - | 1,380 | |
| Long-term debt | 9,633 | 9,645 | 577 | - | 10,222 | |
| Net Carrying | Fair Value Measurements Using | Total | ||||
| As of December 31, 2012 ($ in millions) | Amount | Level 1 | Level 2 | Level 3 | Fair Value | |
| Financial assets: | ||||||
| Cash and due from banks | $ | 2,441 | 2,441 | - | - | 2,441 |
| Other securities | 844 | - | 844 | - | 844 | |
| Held-to-maturity securities | 284 | - | - | 284 | 284 | |
| Other short-term investments | 2,421 | 2,421 | - | - | 2,421 | |
| Loans held for sale | 83 | - | - | 83 | 83 | |
| Portfolio loans and leases: | ||||||
| Commercial and industrial loans | 35,236 | - | - | 36,496 | 36,496 | |
| Commercial mortgage loans | 8,770 | - | - | 8,020 | 8,020 | |
| Commercial construction loans | 665 | - | - | 505 | 505 | |
| Commercial leases | 3,481 | - | - | 3,310 | 3,310 | |
| Residential mortgage loans(a) | 11,712 | - | - | 11,532 | 11,532 | |
| Home equity | 9,875 | - | - | 9,798 | 9,798 | |
| Automobile loans | 11,944 | - | - | 12,076 | 12,076 | |
| Credit card | 2,010 | - | - | 2,139 | 2,139 | |
| Other consumer loans and leases | 270 | - | - | 288 | 288 | |
| Unallocated allowance for loan and lease losses | (111) | - | - | - | - | |
| Total portfolio loans and leases, net(a) | 83,852 | - | - | 84,164 | 84,164 | |
| Financial liabilities: | ||||||
| Deposits | 89,517 | - | 85,592 | - | 85,592 | |
| Federal funds purchased | 901 | 901 | - | - | 901 | |
| Other short-term borrowings | 6,280 | - | 6,280 | - | 6,280 | |
| Long-term debt | 7,085 | 6,925 | 884 | - | 7,809 | |
Cash and due from banks, other securities, other short-term investments, deposits, federal funds purchased and other short-term borrowings
For financial instruments with a short-term or no stated maturity, prevailing market rates and limited credit risk, carrying amounts approximate fair value. Those financial instruments include cash and due from banks, FHLB and FRB restricted stock, other short-term investments, certain deposits (demand, interest checking, savings, money market and foreign office deposits), and federal funds purchased. Fair values for other time deposits, certificates of deposit $100,000 and over and other short-term borrowings were estimated using a discounted cash flow calculation that applied prevailing LIBOR/swap interest rates for the same maturities.
Held-to-maturity securities
The Bancorp's held-to-maturity securities are primarily composed of instruments that provide income tax credits as the economic return on the investment. The fair value of these instruments is estimated based on current U.S. Treasury tax credit rates.
Loans held for sale
Fair values for commercial loans held for sale were valued based on executable bids when available, or on discounted cash flow models incorporating appraisals of the underlying collateral, as well as assumptions about investor return requirements and amounts and timing of expected cash flows. Fair values for other consumer loans held for sale are based on contractual values upon which the loans may be sold to a third party, and approximate their carrying value.
Portfolio loans and leases, net
Fair values were estimated by discounting future cash flows using the current market rates of loans to borrowers with similar credit characteristics and similar remaining maturities.
Long-term debt
Fair values for long-term debt were based on quoted market prices, when available, or a discounted cash flow calculation using LIBOR/swap interest rates and, in some cases, a spread for new issuances with similar terms.