Citigroup Inc.

Bilateral or “own” credit-risk adjustments are applied to reflect theCompany’s own credit risk when valuing derivatives and liabilities measuredat fair value. Counterparty and own credit adjustments consider the expectedfuture cash flows between Citi and its counterparties under the terms ofthe instrument and the effect of credit risk on the valuation of those cashflows, rather than a point-in-time assessment of the current recognized netasset or liability. Furthermore, the credit-risk adjustments take into accountthe effect of credit-risk mitigants, such as pledged collateral and any legalright of offset (to the extent such offset exists) with a counterparty througharrangements such as netting agreements.Auction rate securitiesAuction rate securities (ARS) are long-term municipal bonds, corporatebonds, securitizations and preferred stocks with interest rates or dividendyields that are reset through periodic auctions. The coupon paid in thecurrent period is based on the rate determined by the prior auction. In theevent of an auction failure, ARS holders receive a “fail rate” coupon, which isspecified in the original issue documentation of each ARS.Where insufficient orders to purchase all of the ARS issue to be soldin an auction were received, the primary dealer or auction agent wouldtraditionally have purchased any residual unsold inventory (without acontractual obligation to do so). This residual inventory would then berepaid through subsequent auctions, typically in a short time. Due to thisauction mechanism and generally liquid market, ARS have historicallytraded and were valued as short-term instruments.Citigroup acted in the capacity of primary dealer for approximately$72 billion of ARS and continued to purchase residual unsold inventoryin support of the auction mechanism until mid-February 2008. After thisdate, liquidity in the ARS market deteriorated significantly, auctions faileddue to a lack of bids from third-party investors, and Citigroup ceased topurchase unsold inventory. Following a number of ARS refinancings, atDecember 31, 2010, Citigroup continued to act in the capacity of primarydealer for approximately $23 billion of outstanding ARS.The Company classifies its ARS as held-to-maturity, available-for-sale andtrading securities.Prior to the Company’s first auction’s failing in the first quarter of 2008,Citigroup valued ARS based on observation of auction market prices, becausethe auctions had a short maturity period (7, 28 and 35 days). This generallyresulted in valuations at par. Once the auctions failed, ARS could no longerbe valued using observation of auction market prices. Accordingly, the fairvalues of ARS are currently estimated using internally developed discountedcash flow valuation techniques specific to the nature of the assets underlyingeach ARS.For ARS with U.S. municipal securities as underlying assets, future cashflows are estimated based on the terms of the securities underlying eachindividual ARS and discounted at an estimated discount rate in order toestimate the current fair value. The key assumptions that impact the ARSvaluations are estimated prepayments and refinancings, estimated fail ratecoupons (i.e., the rate paid in the event of auction failure, which variesaccording to the current credit rating of the issuer) and the discount rateused to calculate the present value of projected cash flows. The discountrate used for each ARS is based on rates observed for straight issuances ofother municipal securities. In order to arrive at the appropriate discountrate, these observed rates were adjusted upward to factor in the specifics ofthe ARS structure being valued, such as callability, and the illiquidity in theARS market.For ARS with student loans as underlying assets, future cash flows areestimated based on the terms of the loans underlying each individual ARS,discounted at an appropriate rate in order to estimate the current fair value.The key assumptions that impact the ARS valuations are the expectedweighted average life of the structure, estimated fail rate coupons, theamount of leverage in each structure and the discount rate used to calculatethe present value of projected cash flows. The discount rate used for each ARSis based on rates observed for basic securitizations with similar maturitiesto the loans underlying each ARS being valued. In order to arrive at theappropriate discount rate, these observed rates were adjusted upward to factorin the specifics of the ARS structure being valued, such as callability, and theilliquidity in the ARS market.During the first quarter of 2008, ARS for which the auctions failed andwhere no secondary market has developed were moved to Level 3, as theassets were subject to valuation using significant unobservable inputs. Themajority of ARS continue to be classified as Level 3.Alt-A mortgage securitiesThe Company classifies its Alt-A mortgage securities as held-to-maturity,available-for-sale and trading investments. The securities classified astrading and available-for-sale are recorded at fair value with changes infair value reported in current earnings and AOCI, respectively. For thesepurposes, Citi defines Alt-A mortgage securities as non-agency residentialmortgage-backed securities (RMBS) where (1) the underlying collateral hasweighted average FICO scores between 680 and 720 or (2) for instances whereFICO scores are greater than 720, RMBS have 30% or less of the underlyingcollateral composed of full documentation loans.Similar to the valuation methodologies used for other trading securitiesand trading loans, the Company generally determines the fair values ofAlt-A mortgage securities utilizing internal valuation techniques. Fair-valueestimates from internal valuation techniques are verified, where possible,to prices obtained from independent vendors. Vendors compile prices fromvarious sources. Where available, the Company may also make use ofquoted prices for recent trading activity in securities with the same or similarcharacteristics to the security being valued.262