Fair Value of Financial Instruments

3 Months Ended

Mar. 31, 2012

Fair Value Disclosures [Abstract]

Fair Value of Financial Instruments

Fair Value of Financial Instruments

The Company’s financial instruments consist of cash and cash equivalents, restricted cash and securities, accounts receivable, accounts payable, interest rate swaps and long-term debt (including the current portion) as of March 31, 2012 and December 31, 2011. The carrying values of cash and cash equivalents, restricted cash and securities, accounts receivable, accounts payable, capital leases and other liabilities approximated their fair values at March 31, 2012 and December 31, 2011. The interest rate swaps are recorded in the consolidated balance sheets at fair value. See Note 7 - Derivative Financial Instruments. The carrying value of the Company’s long-term debt, including the current portion, reflects the original amounts borrowed net of unamortized discounts and premiums and was $8.4 billion and $8.5 billion as of March 31, 2012 and December 31, 2011, respectively.

GAAP defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance.

Fair Value Hierarchy

GAAP establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The fair value measurement of each class of assets and liabilities is dependent upon its categorization within the fair value hierarchy, based upon the lowest level of input that is significant to the fair value measurement of each class of asset and liability. GAAP establishes three levels of inputs that may be used to measure fair value:

Level 1—Quoted prices in active markets for identical assets or liabilities.

Level 2—Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3—Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

The table below presents the fair values for each class of Level 3’s liabilities as well as the input levels used to determine these fair values as of March 31, 2012 and December 31, 2011:

					Fair Value Measurement Using
	Total Carrying Value in Consolidated Balance Sheet				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)
	March 31, 2012		December 31, 2011		March 31, 2012		December 31, 2011		March 31, 2012		December 31, 2011
	(dollars in millions)
Liabilities Recorded at Fair Value in the Financial Statements:
Derivatives:
Interest Rate Swap Liabilities (included in other non-current liabilities)	$	83	$	90	$	—	$	—	$	83	$	90
Total Derivative Liabilities Recorded at Fair Value in the Financial Statements	$	83	$	90	$	—	$	—	$	83	$	90
Liabilities Not Recorded at Fair Value in the Financial Statements:
Long-term Debt, including the current portion:
Term Loans	$	2,568	$	2,567	$	2,591	$	2,518	$	—	$	—
Senior Notes	4,807		4,716		5,134		4,822		—		—
Convertible Notes	842		939		329		247		969		834
Commercial Mortgage	64		65		—		—		73		73
Capital Leases and Other	145		163		—		—		145		163
Total Long-term Debt, including the current portion:	$	8,426	$	8,450	$	8,054	$	7,587	$	1,187	$	1,070

The Company does not have any assets or liabilities measured using significant unobservable inputs (Level 3).

Derivatives

The interest rate swaps are measured in accordance with the GAAP Fair Value Measurements and Disclosures guidance using discounted cash flow techniques that use observable market inputs, such as LIBOR-based forward yield curves, forward rates, and the specific swap rate stated in each of the swap agreements.

Term Loans

The fair value of the Term Loans was approximately $2.6 billion and $2.5 billion at March 31, 2012 and December 31, 2011, respectively.  The fair value of each loan is based on the March 31, 2012 and December 31, 2011 trading quotes as provided by large financial institutions that trade in the Company’s Term Loans. The pricing quotes provided by these market participants incorporate LIBOR curve expectations, interest spread, corporate and loan credit ratings, maturity date (March 2014 and September 2018) and liquidity, among other loan characteristics and relative value across other instruments of similar terms. The interest spread, for the $1.4 billion Tranche A Term Loan is LIBOR plus 2.25% (aggregate principal value) and LIBOR plus 4.25% with a LIBOR floor of 1.5% for the Tranche B II and Tranche B III Term Loans, respectively. See Note 8 - Long-Term Debt for details.

The Term Loans are secured by a pledge of the equity interests in certain U.S.-based subsidiaries of Level 3 Financing; 65% of the equity interests in each of Level 3 Financing’s Canadian subsidiary, and its Bermuda subsidiary that indirectly owns Global Crossing's non-U.S. subsidiaries; and liens on the assets of Level 3 Communications, Inc. and certain U.S.-based subsidiaries of Level 3 Financing.  In addition, Level 3 Communications, Inc. and certain U.S.-based subsidiaries of Level 3 Financing have provided full and unconditional guarantees of the obligations under the Term Loans.

Senior Notes

The estimated fair value of the Company’s Senior Notes approximated $5.1 billion and $4.8 billion at March 31, 2012 and December 31, 2011, respectively, based on market prices. The fair value of each instrument was based on the March 31, 2012 and December 31, 2011 trading quotes as provided by large financial institutions that trade in the Company’s securities. The pricing quotes provided by these market participants incorporate spreads to the Treasury curve, security coupon (which ranges from LIBOR plus 2.25% to 11.875%), corporate and security credit ratings, maturity date (ranging from 2014 to 2020) and liquidity, among other security characteristics and relative value at both the borrower entity level and across other securities of similar terms.

The 11.875% Senior Notes due 2019 are obligations of the Company and are not guaranteed by its subsidiaries.  The remaining Senior Notes are obligations of Level 3 Financing, Inc. and as of April 30, 2012, are all fully and unconditionally guaranteed by Level 3 Communications, Inc. and Level 3 Communications, LLC.

Convertible Notes

The estimated fair value of the Company’s actively traded 6.5% Convertible Senior Notes due 2016 was approximately $329 million at March 31, 2012 and $247 million at December 31, 2011. The fair value of the Company’s actively traded Convertible Notes is based on the trading quotes as of March 31, 2012 and December 31, 2011 provided by large financial institutions that trade in the Company’s securities. The estimated fair value of the Company’s Convertible Notes that are not actively traded, such as the 7% Convertible Senior Notes due 2015, the 7% Convertible Senior Notes due 2015, Series B, and the 15% Convertible Senior Notes due 2013, approximated $969 million at March 31, 2012 and $834 million at December 31, 2011. A portion of the Company's 15% Convertible Senior Notes due 2013 were exchanged for equity during the first quarter of 2012, as discussed in Note 8 - Long-Term Debt. To estimate the fair value of the Convertible Notes that are not actively traded, Level 3 used a Black-Scholes valuation model and an income approach using discounted cash flows. The most significant inputs affecting the valuation are the pricing quotes provided by market participants that incorporate spreads to the Treasury curve, security coupon (ranging from 7% to 15%), convertible optionality, corporate and security credit ratings, maturity date (ranging from 2013 to 2015), liquidity, and other equity option inputs, such as the risk-free rate, underlying stock price, strike price of the embedded derivative, estimated volatility and maturity inputs for the option component and for the bond component, among other security characteristics and relative value at both the borrower entity level and across other securities with similar terms. The fair value of each instrument is obtained by adding together the value derived by discounting the security’s coupon or interest payment using a risk-adjusted discount rate and the value calculated from the embedded equity option based on the estimated volatility of the Company’s stock price, conversion rate of the particular Convertible Note, remaining time to maturity, and risk-free rate. The Convertible Notes are unsecured obligations of Level 3 Communications, Inc. No subsidiary of Level 3 Communications, Inc. has provided a guarantee of the Convertible Notes.

Commercial Mortgage

The fair value of the Commercial Mortgage was approximately $73 million at both March 31, 2012 and December 31, 2011, respectively, as compared to the carrying amounts of $64 million and $65 million, respectively.  The Commercial Mortgage is not actively traded and its fair value is estimated by management using a valuation model based on an income approach.  The significant inputs used to estimate fair value of this debt instrument using discounted cash flows include the anticipated scheduled mortgage payments and observable market yields on other actively traded debt of similar characteristics and collateral type.

The Commercial Mortgage is a secured obligation of HQ Realty, Inc., a wholly owned subsidiary of the Company. HQ Realty, Inc.’s obligations under the Commercial Mortgage are secured by a first priority lien on the Company’s headquarters campus located at 1025 Eldorado Boulevard, Broomfield, Colorado 80021 and certain HQ Realty, Inc. cash and reserve accounts.

The assets of HQ Realty, Inc. are not available to satisfy any third party obligations other than those of HQ Realty, Inc. In addition, the assets of the Company and its subsidiaries other than HQ Realty, Inc. are not available to satisfy the obligations of HQ Realty, Inc.