Family Finance Co. (FFC), a publicly traded commercial bank located in South Carolina, has a December 31 year-end. FFC invests in a variety of securities to enhance returns, managing its investment portfolio in an effort to earn returns greater than interest paid on bank deposits and other liabilities. As of December 31, 2019, FFC's investments primarily consist of (1) mortgage-backed securities (MBSs), (2) equity securities of nonpublic companies, and (3) "plain vanilla" interest rate swaps that FFC uses to hedge its exposure to variable interest rates on its corporate debt. All cash payments made under these instruments are in U.S. dollars.

FFC accounts for its investments at fair value with changes in fair value reflected either in earnings or other comprehensive income (OCI). Because FFC uses the interest rate swap in a cash-flow hedge, it measures the derivative at fair value, presenting the portion of the fair value change that effectively offsets cash flow variability on its corporate debt in OCI and the remainder in earnings.

Facts related to specific securities and derivatives owned by FFC are described below.

Instrument 1 Mortgage-Backed Security

On September 1, 2019, FFC invested in an S&P AA-rated tranche of a privately issued pass-through MBS (i.e., nonagency) with a stated maturity of 30 years. The underlying collateral for the MBS is subprime mortgages on residential properties.

On September 30, 2019, FFC measured the fair value of the MBS using a market approach valuation technique that was based on inputs that did not require a significant adjustment. These inputs included quoted prices in active markets for similar MBSs with insignificant adjustments for differences between the MBS held by FFC and similar securities.

In Q4 2019, the market for the MBS became increasingly volatile with some periods of declining activity. The volatility was evidenced through fluctuating bid-ask spreads. However, FFC concluded that (1) there were observable transactions for the MBS or similar MBSs and (2) the prices for those transactions were current and therefore did not reduce their relevance to the fair value measurement. On the basis of the evidence, FFC determined that the observed transactions were orderly and that the adjustments to the observed transactions required to measure fair value for its MBS are insignificant on the measurement date.

As an alternative, FFC considered using a theoretical income-approach pricing model. Such a pricing model takes into account the relationship between interest rates and loan prepayment speeds. Mortgage prepayments are usually made because either a home is sold or the homeowner is refinancing to a new mortgage, presumably with a lower interest rate. Since these two sources of risk (interest rate and prepayment) are linked, this relationship must be factored into the model. FFC recognized that there would be substantial complexity in using an appropriate mathematical model for valuing its MBS.

FFC measured the fair value for its MBS by using only the observed market transactions referenced above because the alternative pricing model was inherently complex and would require significant assumptions.

Instrument 2 Equity Investment in a Nonpublic Company

In 2015, FFC invested in the common stock of Company X, a privately held clothing retailer that operates in a niche market of the baby clothing industry. Quoted prices are not available for X's stock.² Most of X's competitors are either privately held or subsidiaries of larger publicly traded clothing retailers. Company X is similar to two other organizations whose shares are thinly traded in an observable market.

Note that the security does not have a readily determinable fair value. However, FFC has not elected the accounting alternative for this investment in ASC 321, and thus accounts for the investment at fair value with changes in fair value recorded through earnings.

In determining an appropriate approach for measuring the fair value of its equity investment in X, FFC considered the following factors to establish whether a single or multiple valuation techniques should be adopted:

Availability and reliability of data FFC had sufficient data to support both the income and market approaches.

Comparative levels of the alternative approaches in the fair value hierarchy When using a market approach to measure the fair value of its investment in X, FFC would need to make significant entity-specific adjustments to observable market transactions (i.e., risk-adjustments for illiquidity, uncertainty of X's future financial performance in relation to its comparables, and other adjustments to reflect business model differences between X and its comparables). Similarly, when measuring fair value using an income approach (on the basis of discounted cash flows), FFC would be required to use significant entity-specific assumptions in forecasting X's future cash flows.

Views of market participants on the relevance of valuation techniques Through discussions with valuation specialists, FFC believes that market participants use multiple techniques (income and market approaches) to determine bid prices for similar investments. FFC also used both approaches in 2015 when pricing its investment in X.

Considering this information, in 2015 FFC determined that it would use both market and income approaches (weighted equally) to measure the fair value of its investment in X. FFC has applied a consistent approach during 2019.

Instrument 3 Interest Rate Swap

In January 2018, FFC executed a "plain-vanilla" over-the-counter (OTC) fixed-for-float interest rate (IR) swap as an economic hedge of its cash flow variability to changes in the London Interbank Offered Rate (LIBOR) on its four-year variable-rate term note. The terms of the IR swap require FFC to pay a fixed rate and receive a floating rate (three-month LIBOR). The IR swap net cash settles on a quarterly basis. If the fixed rate exceeds the floating rate, FFC makes a net payment to the counterparty, and if the floating rate exceeds the fixed rate, FFC receives a net payment from the counterparty. As of the measurement date (December 31, 2019), the remaining life of the IR swap was two years.

FFC uses an income approach (i.e., a discounted cash flow model), which is widely accepted for valuing IR swaps. Key inputs into the valuation model are the LIBOR yield curve and an adjustment, if any, for nonperformance risk, which is the risk that a party to the contract will not satisfy its obligation (also known as a credit valuation adjustment (CVA)). FFC obtained a quoted LIBOR yield curve for the entire term of the IR swap. In addition, FFC concluded that no CVA was necessary.

Required:

Determine the appropriate classification in the fair value hierarchy for each of the instruments referenced in the case as of December 31, 2019. Provide support from appropriate authoritative guidance.