5  FAIR VALUE MEASUREMENTS

The guidance for fair value measurement 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 (an exit price). The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures. The guidance for fair value measurement details the disclosures that are required for items measured at fair value.

We have various financial instruments we must measure at fair value on a recurring basis, including certain marketable securities, derivatives, and residual interests related to our asset securitizations. We also apply the provisions of fair value measurement to various non-recurring measurements for our financial and non-financial assets and liabilities, which included the impairment of a joint venture investment, and two security deposits in the first quarter of 2009, the impairment of Timeshare segment inventory, property and equipment, anticipated fundings in conjunction with certain purchase commitments, and a joint venture investment in the third quarter of 2009, and the impairment of a joint venture investment and an intangible asset in the fourth quarter of 2009. See Footnote No. 21, "Restructuring Costs and Other Charges," and Footnote No. 20, "Timeshare Strategy – Impairment Charges," for further information. We measure our assets and liabilities using inputs from the following three levels of the fair value hierarchy:

Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access at the measurement date.

Level 2 inputs include 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, inputs other than quoted prices that are observable for the asset or liability (i.e., interest rates, yield curves, etc.), and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs).

Level 3 includes unobservable inputs that reflect our assumptions about what factors market participants would use in pricing the asset or liability. We develop these inputs based on the best information available, including our own data.

In accordance with the fair value hierarchy, the following table shows the fair value as of year-end 2009, of those assets and liabilities that we must measure at fair value on a recurring basis and that we classify as "Other current assets," "Other assets," "Other current liabilities," and "Other long-term liabilities":

The following table summarizes the changes in fair value of our Level 3 assets and liabilities for year-end 2009:

As discussed in more detail in Footnote No. 13, "Asset Securitizations," we periodically sell notes receivable originated by our Timeshare segment. We continue to service the notes after the sale, and we retain servicing assets and other interests in the notes and account for these assets and interests as residual interests. At the dates of sale and at the end of each reporting period, we estimate the fair value of our residual interests using a discounted cash flow model. These transactions may utilize interest rate swaps to protect the net interest margin associated with the beneficial interest.

The most significant estimate involved in the measurement process is the discount rate, followed by the default rate and the loan prepayment rate. Estimates of these rates are based on management's expectations of future prepayment rates and default rates, reflecting our historical experience, industry trends, current market interest rates, expected future interest rates, and other considerations. Actual prepayment rates, default rates, and discount rates could differ from those projected by management due to changes in a variety of economic factors, including prevailing interest rates and the availability of alternative financing sources to borrowers. If actual prepayments of the notes being serviced were to occur more slowly than had been projected, or if actual default rates or actual discount rates are lower than expected, the carrying value of servicing assets could increase and accretion and servicing income would exceed previously projected amounts. Conversely, if actual prepayments occur at a faster than projected pace, or if actual default or actual discount rates are higher than we expect, the carrying value of servicing assets could decrease and accretion and servicing income would be below previously projected amounts. Accordingly, the residual interests actually realized, could differ from the amounts initially or currently recorded.

The discount rates we use in determining the fair values of our residual interests are based on the volatility characteristics (i.e., defaults and prepayments) of the residual assets. We assume increases in the default and prepayment rates and discount the resulting cash flows with a low risk rate to derive a stressed asset value. The low risk rate approximates credit spreads in the current market. Using our base case cash flows, we then determine the discount rate, which when applied to the base case cash flows, produces the stressed asset value, which we assume approximates an exit price for the residual assets. We adjust discount rates quarterly as interest rates, credit spreads, and volatility characteristics in the market fluctuate.

As noted in the "Residual Interests" caption of Footnote No. 1, "Summary of Significant Accounting Policies," we treat the residual interests, including servicing assets, as trading securities under the provisions of accounting for certain investments in debt and equity securities. During 2009 and 2008, we recorded trading gains of $18 million and losses of $9 million, respectively, and in 2007, we recorded trading gains of $30 million.

During 2009, 2008, and 2007, we used the following key assumptions to measure, at the date of sale, the fair value of the residual interests, including servicing assets: average discount rates of 12.53 percent, 9.23 percent, and 9.02 percent, respectively; average expected annual prepayments, including defaults, of 19.46 percent, 24.01 percent, and 25.02 percent, respectively; expected weighted average life of prepayable notes receivable, excluding prepayments and defaults, of 72 months, 76 months, and 75 months, respectively; and expected weighted average life of prepayable notes receivable, including prepayments and defaults, of 38 months, 35 months, and 34 months, respectively. Our key assumptions are based on experience with notes receivable and servicing assets.

We used the following key assumptions in measuring the fair value of the residual interests, including servicing assets, in our 13 outstanding Timeshare note sales as of year-end 2009: an average discount rate of 16.06 percent; an average expected annual prepayment rate, including defaults, of 15.58 percent; an expected weighted average life of prepayable notes receivable, excluding prepayments and defaults, of 57 months; and an expected weighted average life of prepayable notes receivable, including prepayments and defaults, of 37 months.

We completed a stress test on the fair value of the residual interests, including servicing assets, as of the end of 2009 to measure the change in value associated with independent changes in individual key variables. This methodology applied unfavorable changes that would be statistically significant for the key variables of prepayment rate, discount rate, and weighted average remaining term. Before we applied any of these stress test changes, we determined that the fair value of the residual interests, including servicing assets, was $214 million as of year-end 2009.

Applying the stress tests, we concluded that each change to a variable shown in the table below would have the following impact on the valuation of our residual interests as of year-end 2009:

We value our Level 3 input derivatives using valuations that are calibrated to the initial trade prices. Subsequent valuations are based on unobservable inputs to the valuation model including interest rates and volatilities. We record realized and unrealized gains and losses on these derivative instruments in gains from the sale of timeshare notes receivable, which are recorded within the "Timeshare sales and services" revenue caption in our Consolidated Statements of Income.

In connection with the first and fourth quarter 2009 note sales, on the date of transfer, we recorded notes that we effectively owned after the transfer at a fair value of $81 million and $57 million, respectively. We used a discounted cash flow model, including Level 3 inputs, to determine the fair value of notes we effectively owned after the transfer. We based the discount rate we used in determining the fair value on the methodology described earlier in this footnote. Other assumptions, such as default and prepayment rates, are consistent with those used in determining the fair value of our residual interests. For additional information, see Footnote No. 13, "Asset Securitizations."

During 2009, we recorded $90 million of impairment charges for two of our security deposits, one intangible asset, and two joint venture investments, prior to the application of an $11 million liability remaining from 2008. These charges are reflected in our Consolidated Statement of Income as $57 million in the "General, administrative, and other" expense caption and $33 million in the "Equity in (losses) earnings" caption. For additional information, see Footnote No. 21, "Restructuring Costs and Other Charges."

During 2009, we also recorded an other-than-temporary impairment charge related to marketable equity securities. This charge is reflected in our Consolidated Statement of Income as $5 million in the "Gains and other income" caption. We measure these securities using Level 1 inputs on a recurring basis.

In 2009, in conjunction with our evaluation of the entire Timeshare portfolio and our resulting decisions to adjust the business strategy to reflect current market conditions, we recorded $685 million of impairment charges in accordance with the guidance for fair value measurement for inventory, property and equipment, anticipated fundings in conjunction with certain purchase commitments, and one joint venture investment. We reflected these charges in our Consolidated Statement of Income as $614 million in the "Timeshare strategy – impairment charges" caption and $71 million in the "Timeshare strategy – impairment charges (non-operating)" caption. For additional information, see Footnote No. 20, "Timeshare Strategy – Impairment Charges."

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