Fair value of financial instruments

3 Months Ended

Mar. 31, 2012

Fair value of financial instruments

Note 14 – Fair value of financial instruments

The carrying amounts of our financial instruments (i.e., monetary assets and liabilities) are determined under different accounting methods – see Note 1 to the Consolidated Financial Statements contained in the 2011 Annual Report. The following disclosure discusses these instruments on a uniform fair value basis. However, active markets do not exist for a significant portion of these instruments. For financial instruments where quoted prices from identical assets and liabilities in active markets do not exist, we determine fair value based on discounted cash flow analysis and comparison to similar instruments. Discounted cash flow analysis is dependent upon estimated future cash flows and the level of interest rates. Other judgments would result in different fair values. Among the assumptions we used are discount rates ranging principally from 0.24% to 5.07% at March 31, 2012 and 0.01% to 4.17% at Dec. 31, 2011. The fair value information supplements the basic financial statements and other traditional financial data presented throughout this report.

Note 15, “Fair value measurement”, presents assets and liabilities recorded at fair value on the balance sheet by the three-level valuation hierarchy established under ASC 820. Note 16, “Fair value option”, presents the instruments for which fair value accounting was elected and the corresponding income statement impact of those instruments. A summary of the practices used for determining fair value for financial assets and liabilities not recorded at fair value is as follows.

Valuation hierarchy

ASC 820 established a three-level valuation hierarchy for disclosure of fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are described below.

Level 1: Inputs to the valuation methodology are recent quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 1 assets and liabilities include cash and U.S. Treasury securities.

Level 2: Observable inputs other than Level 1 prices, for example, quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs that are observable or can be corroborated, either directly or indirectly, for substantially the full term of the financial instrument. Level 2 assets and liabilities include interest-bearing deposits with banks, including the Federal Reserve Bank and other central banks; federal funds purchased or sold and securities purchased or sold under resale agreements; agency and non-agency mortgage-backed securities, and commercial mortgage-backed securities; loans; Federal Reserve Bank stock; demand, money market, savings and time deposits; payables to customers and broker-dealers; borrowings; and long-term debt.

Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Interest-bearing deposits with the Federal Reserve and other central banks and interest-bearing deposits with banks

The estimated fair value of interest-bearing deposits with the Federal Reserve and other central banks is equal to the book value as these interest-bearing deposits are generally considered cash equivalents. These instruments are classified as Level 2 within the valuation hierarchy. The estimated fair value of interest-bearing deposits with banks is generally determined using discounted cash flows and duration of the instrument to maturity. The primary inputs used to value these transactions are interest rates based on current LIBOR market rates and time to maturity. Interest-bearing deposits with banks are classified as Level 2 within the valuation hierarchy.

Federal funds sold and securities purchased under resale agreements

The estimated fair value of federal funds sold and securities purchased under resale agreements is based on inputs such as interest rates and tenors. Federal funds sold and securities purchased under resale agreements are classified as Level 2 within the valuation hierarchy.

Securities held-to-maturity

Where quoted prices are available in an active market for identical assets and liabilities, we classify the securities as Level 1 within the valuation hierarchy. Securities are defined as both long and short positions. Level 1 includes U.S. Treasury securities.

If quoted market prices are not available for identical assets and liabilities, we estimate fair value using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Examples of such instruments, which would generally be classified as Level 2 within the valuation hierarchy, include certain agency and non-agency mortgage-backed securities, commercial mortgage-backed securities and state and political subdivision securities.

For securities where quotes from active markets are not available for identical securities, we determine fair value primarily based on pricing sources with reasonable levels of price transparency that employ financial models or obtain comparison to similar instruments to arrive at “consensus” prices.

Specifically, the pricing sources obtain active markets for similar types of securities (e.g., vintage, position in the securitization structure) and ascertain variables such as discount rate and speed of prepayment for the types of transaction and apply such variables to similar types of bonds. We view these as observable transactions in the current marketplace and classify such securities as Level 2 within the valuation hierarchy.

Loans

For residential mortgage loans, fair value is estimated using discounted cash flow analyses, adjusting where appropriate for prepayment estimates, using interest rates currently being offered for loans with similar terms and maturities to borrowers. The estimated fair value of margin loans and overdrafts is equal to the book value due to the short-term nature of these assets. The estimated fair value of other types of loans is determined using discounted cash flows. Inputs include current LIBOR market rates adjusted for credit spreads. These loans are generally classified as Level 2 within the valuation hierarchy.

Other financial assets

Other financial assets include cash, Federal Reserve Bank stock and accrued interest receivable. Cash is classified as Level 1 within the valuation hierarchy. The Federal Reserve Bank stock is not redeemable or transferable. The estimated fair value of the Federal Reserve Bank stock is based on the redemption price and is classified as Level 2 within the valuation hierarchy. Accrued interest receivable is generally short-term. As a result, book value is considered to equal fair value. Accrued interest receivable is included as Level 2 within the valuation hierarchy.

Noninterest-bearing and interest-bearing deposits

Interest-bearing deposits are comprised of demand, money markets, savings deposits and time deposits. Except for time deposits, book value is considered to equal fair value for these deposits due to their short duration to maturity or payable on demand feature. The fair value of interest-bearing time deposits is determined using discounted cash flow analysis. Inputs primarily consist of current LIBOR market rates and time to maturity. For all noninterest-bearing deposits, book value is considered to equal fair value as a result of the short duration of the deposit. Interest-bearing and noninterest-bearing deposits are classified as Level 2 within the valuation hierarchy.

Federal funds purchased and securities sold under repurchase agreements

The estimated fair value of federal funds purchased and securities sold under resale agreements is based on inputs such as interest rates and tenors. Federal funds purchased and securities sold under resale agreements are classified as Level 2 within the valuation hierarchy.

Payables to customers and broker-dealers

The estimated fair value of payables to customers and broker-dealers is equal to the book value due to demand feature of the payables to customers and broker-dealers and are classified as Level 2 within the valuation hierarchy.

Borrowings

Borrowings primarily consist of overdrafts of subcustodian account balances in our Investment Services businesses, commercial paper and accrued interest payable. The estimated fair value of overdrafts of subcustodian account balances in our Investment Services businesses is considered to equal book value as a result of the short duration of the overdrafts. Overdrafts are typically repaid within two days. The estimated fair value of our commercial paper is based on discount and duration of the commercial paper. Our commercial paper matures within 397 days from date of issue and is not redeemable prior to maturity or subject to voluntary prepayment. Our commercial paper is included in Level 2 of the valuation hierarchy.

Accrued interest payable is generally short-term. As result, book value is considered to equal fair value. Accrued interest payable is included as Level 2 within the valuation hierarchy.

Long-term debt

The estimated fair value of long-term debt is based on current rates for instruments of the same remaining maturity or quoted market prices for the same or similar issues. Long-term debt is classified as Level 2 within the valuation hierarchy.

Summary of financial instruments	March 31, 2012										Dec. 31, 2011
(in millions)	Level 1		Level 2		Level 3		Total estimated fair value		Carrying amount		Estimated fair value		Carrying amount
Assets:
Interest-bearing deposits with the Federal Reserve and other central banks	$	-	$	62,030	$	-	$	62,030	$	62,030	$	90,243	$	90,243
Interest-bearing deposits with banks		-		34,902		-		34,902		34,854		36,381		36,321
Federal funds sold and securities purchased under resale agreements		-		5,437		-		5,437		5,437		4,510		4,510
Securities held-to-maturity		905		3,944		-		4,849		4,819		3,540		3,521
Loans		-		40,180		-		40,180		40,074		41,166		40,970
Other financial assets		4,333		1,156		-		5,489		5,489		5,336		5,336
Total	$	5,238	$	147,649	$	-	$	152,887	$	152,703	$	181,176	$	180,901
Liabilities:
Noninterest-bearing deposits	$	-	$	65,027	$	-	$	65,027	$	65,027	$	95,335	$	95,335
Interest-bearing deposits		-		127,436		-		127,436		127,435		123,759		123,759
Federal funds purchased and securities sold under repurchase agreements		-		8,285		-		8,285		8,285		6,267		6,267
Payables to customers and broker-dealers		-		12,959		-		12,959		12,959		12,671		12,671
Borrowings		-		3,365		-		3,365		3,365		2,376		2,376
Long-term debt		-		21,003		-		21,003		20,336		20,459		19,933
Total	$	-	$	238,075	$	-	$	238,075	$	237,407	$	260,867	$	260,341

The table below summarizes the carrying amount of the hedged financial instruments, the notional amount of the hedge and the unrealized gain (loss) (estimated fair value) of the derivatives.

Hedged financial instruments	Carrying amount		Notional amount of hedge		Unrealized
(in millions)					Gain		(Loss)
At March 31, 2012:
Interest-bearing deposits with banks	$	9,211	$	9,211	$	42	$	-
Securities available-for-sale		4,642		4,540		84		(160	)
Deposits		10		10		1		-
Long-term debt		15,925		15,233		901		(18	)
At Dec. 31, 2011:
Interest-bearing deposits with banks	$	8,789	$	8,789	$	441	$	(17	)
Securities available-for-sale		4,354		4,009		-		(289	)
Deposits		10		10		1		-
Long-term debt		15,048		14,262		964		(9	)