Ally Bank 2012 Annual Report Download - page 89

87
and geographic information. Management monitors the adequacy of the allowance and makes adjustments as the assumptions in the
underlying analyses change to reflect an estimate of incurred loan losses at the reporting date, based on the best information available at that
time. In addition, the allowance related to the commercial portfolio segment is influenced by estimated recoveries from automotive
manufacturers relative to guarantees or agreements with them to repurchase vehicles used as collateral to secure the loans. If an automotive
manufacturer is unable to fully honor its obligations, our ultimate loan losses could be higher. To the extent that actual outcomes differ from
our estimates, additional provision for credit losses may be required that would reduce earnings.
Valuation of Automobile Lease Assets and Residuals
We have significant investments in vehicles in our operating lease portfolio. In accounting for operating leases, management must make
a determination at the beginning of the lease contract of the estimated realizable value (i.e., residual value) of the vehicle at the end of the
lease. Residual value represents an estimate of the market value of the vehicle at the end of the lease term, which typically ranges from two to
four years. At contract inception, we generally determine the projected residual values based on independent data, including independent
guides of vehicle residual values, and analysis. Risk adjustments are determined at lease inception and are based on current auction results
adjusted for key variables that historically have shown an impact on auction values (as further described in the Lease Residual Risk
discussion in the Risk Management section of this MD&A). The customer is obligated to make payments during the term of the lease for the
difference between the purchase price and the contract residual value plus a finance charge. However, since the customer is not obligated to
purchase the vehicle at the end of the contract, we are exposed to a risk of loss to the extent the value of the vehicle is below the residual
value estimated at contract inception. Management periodically performs a detailed review of the estimated realizable value of leased vehicles
to assess the appropriateness of the carrying value of lease assets.
To account for residual risk, we depreciate automobile operating lease assets to estimated realizable value on a straight-line basis over
the lease term. The estimated realizable value is initially based on the residual value established at contract inception. Over the life of the
lease, management evaluates the adequacy of the estimate of the realizable value and may make adjustments to the extent the expected value
of the vehicle at lease termination changes. Any adjustments would result in a change in the depreciation rate of the lease asset, thereby
affecting the carrying value of the operating lease asset.
In addition to estimating the residual value at lease termination, we must also evaluate the current value of the operating lease assets and
test for impairment to the extent necessary in accordance with applicable accounting standards. Impairment is determined to exist if the
undiscounted expected future cash flows (including the expected residual value) are lower than the carrying value of the asset. There were no
such impairment charges in 2012, 2011, or 2010.
Our depreciation methodology on operating lease assets considers management's expectation of the value of the vehicles upon lease
termination, which is based on numerous assumptions and factors influencing used vehicle values. The critical assumptions underlying the
estimated carrying value of automobile lease assets include: (1) estimated market value information obtained and used by management in
estimating residual values, (2) proper identification and estimation of business conditions, (3) our remarketing abilities, and (4) automotive
manufacturer vehicle and marketing programs. Changes in these assumptions could have a significant impact on the value of the lease
residuals. Expected residual values include estimates of payments from automotive manufacturers related to residual support and risk-sharing
agreements. To the extent an automotive manufacturer is not able to fully honor its obligation relative to these agreements, our depreciation
expense would be negatively impacted.
Valuation of Mortgage Servicing Rights
Mortgage servicing rights represent the capitalized value of the right to receive future cash flows from the servicing of mortgage loans
for others. Mortgage servicing rights are a significant source of value derived from the sale or securitization of mortgage loans. Because
residential mortgage loans typically contain a prepayment option, borrowers may often elect to prepay their mortgage loans by refinancing at
lower rates during declining interest rate environments. The borrower's ability to prepay is at times impacted by other factors in the current
environment that may limit their eligibility to refinance (e.g. a high loan-to-value ratio). When this occurs, the stream of cash flows generated
from servicing the original mortgage loan is terminated. As such, the market value of mortgage servicing rights has historically been very
sensitive to changes in interest rates and tends to decline as market interest rates decline and increase as interest rates rise.
We capitalize mortgage servicing rights on residential mortgage loans that we have originated and purchased based on the fair market
value of the servicing rights associated with the underlying mortgage loans at the time the loans are sold or securitized. GAAP requires that
the value of mortgage servicing rights be determined based on market transactions for comparable servicing assets, if available. In the absence
of representative market trade information, valuations should be based on other available market evidence and modeled market expectations
of the present value of future estimated net cash flows that market participants would expect from servicing. When observable prices are not
available, management uses internally developed discounted cash flow models to estimate the fair value. These internal valuation models
estimate net cash flows based on internal operating assumptions that we believe would be used by market participants, combined with market-
based assumptions for loan prepayment rates, interest rates, default rates and discount rates that management believes approximate yields
required by investors for these assets. Servicing cash flows primarily include servicing fees, escrow account income, ancillary income and late
fees, less operating costs to service the loans. The estimated cash flows are discounted using an option-adjusted spread-derived discount rate.
Management considers the best available information and exercises significant judgment in estimating and assuming values for key variables
in the modeling and discounting process. All of our mortgage servicing rights are carried at estimated fair value.
Table of Contents
Management's Discussion and Analysis
Ally Financial Inc. • Form 10-K