Ally Bank 2014 Annual Report Download - page 85

Table of Contents
Management's Discussion and Analysis
Ally Financial Inc. • Form 10-K
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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 Automotive 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 determine the projected residual value based on an internal evaluation of the expected future value. This
evaluation is based on a proprietary model, which includes variables such as age, expected mileage, seasonality, segment factors, vehicle type,
economic indicators, production cycle, automotive manufacturer incentives, and shifts in used vehicle supply. This internally-generated data
is compared against third party, independent data for reasonableness. 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 automotive 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. Periodically, we revise
the projected value of the lease vehicle at termination based on current market conditions, and other relevant data points, and adjust
depreciation expense appropriately over the remaining term of the lease. Impairment of the operating lease asset is assessed upon the
occurrence of a triggering event. Triggering events are systemic, observed events impacting the used car market such as shocks to oil and gas
prices that may indicate impairment of the operating lease asset. Impairment is determined to exist if the expected undiscounted cash flows
generated from the operating lease assets are less than the carrying value of the operating lease assets. If the operating lease assets are
impaired, they are written down to their fair value as estimated by discounted cash flows. There were no such impairment charges in 2014,
2013, or 2012.
Our depreciation methodology for 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 automotive 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, if any. 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.
Fair Value of Financial Instruments
We use fair value measurements to record fair value adjustments to certain instruments and to determine fair value disclosures. Refer to
Note 25 to the Consolidated Financial Statements for a description of valuation methodologies used to measure material assets and liabilities
at fair value and details of the valuation models, key inputs to those models, and significant assumptions utilized. We follow the fair value
hierarchy set forth in Note 25 to the Consolidated Financial Statements in order to prioritize the inputs utilized to measure fair value. We
review and modify, as necessary, our fair value hierarchy classifications on a quarterly basis. As such, there may be reclassifications between
hierarchy levels.
We have numerous internal controls in place to ensure the appropriateness of fair value measurements. Significant fair value measures
are subject to detailed analytics and management review and approval. We have an established model validation policy and program in place
that covers all models used to generate fair value measurements. This model validation program ensures a controlled environment is used for
the development, implementation, and use of the models and change procedures. Further, this program uses a risk-based approach to select
models to be reviewed and validated by an independent internal risk group to ensure the models are consistent with their intended use, the
logic within the models is reliable, and the inputs and outputs from these models are appropriate. Additionally, a wide array of operational
controls are in place to ensure the fair value measurements are reasonable, including controls over the inputs into and the outputs from the fair
value measurement models. For example, we backtest the internal assumptions used within models against actual performance. We also
monitor the market for recent trades, market surveys, or other market information that may be used to benchmark model inputs or outputs.
Certain valuations will also be benchmarked to market indices when appropriate and available. We have scheduled model and/or input
recalibrations that occur on a periodic basis but will recalibrate earlier if significant variances are observed as part of the backtesting or
benchmarking noted above.
Considerable judgment is used in forming conclusions from market observable data used to estimate our Level 2 fair value
measurements and in estimating inputs to our internal valuation models used to estimate our Level 3 fair value measurements. Level 3 inputs
such as interest rate movements, prepayment speeds, credit losses, and discount rates are inherently difficult to estimate. Changes to these
inputs can have a significant effect on fair value measurements. Accordingly, our estimates of fair value are not necessarily indicative of the
amounts that could be realized or would be paid in a current market exchange.