Wells Fargo 2006 Annual Report Download - page 40

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Critical Accounting Policies
Our significant accounting policies (see Note 1 (Summary of
Significant Accounting Policies) to Financial Statements) are
fundamental to understanding our results of operations and
financial condition, because some accounting policies require
that we use estimates and assumptions that may affect the
value of our assets or liabilities and financial results. Three
of these policies are critical because they require manage-
ment to make difficult, subjective and complex judgments
about matters that are inherently uncertain and because it
is likely that materially different amounts would be reported
under different conditions or using different assumptions.
These policies govern the allowance for credit losses, the
valuation of residential mortgage servicing rights (MSRs)
and pension accounting. Management has reviewed and
approved these critical accounting policies and has discussed
these policies with the Audit and Examination Committee.
Allowance for Credit Losses
The allowance for credit losses, which consists of the
allowance for loan losses and the reserve for unfunded credit
commitments, is management’s estimate of credit losses
inherent in the loan portfolio at the balance sheet date. We
have an established process, using several analytical tools and
benchmarks, to calculate a range of possible outcomes and
determine the adequacy of the allowance. No single statistic
or measurement determines the adequacy of the allowance.
Loan recoveries and the provision for credit losses increase
the allowance, while loan charge-offs decrease the allowance.
PROCESS TO DETERMINE THE ADEQUACY OF THE ALLOWANCE
FOR CREDIT LOSSES
While we attribute portions of the allowance to specific
loan categories as part of our analytical process, the entire
allowance is used to absorb credit losses inherent in the total
loan portfolio.
A significant portion of the allowance, approximately
70% at December 31, 2006, is estimated at a pooled level
for consumer loans and some segments of commercial small
business loans. We use forecasting models to measure the
losses inherent in these portfolios. We independently validate
and update these models at least annually to capture recent
behavioral characteristics of the portfolios, such as updated
credit bureau information, actual changes in underlying
economic or market conditions and changes in our loss
mitigation or marketing strategies.
The remainder of the allowance is for commercial loans,
commercial real estate loans and lease financing. We initially
estimate this portion of the allowance by applying historical
loss factors statistically derived from tracking losses associated
with actual portfolio movements over a specified period of
time, using a standardized loan grading process. Based on
this process, we assign loss factors to each pool of graded
loans and a loan equivalent amount for unfunded loan
commitments and letters of credit. These estimates are then
adjusted or supplemented where necessary from additional
analysis of long-term average loss experience, external loss
data or other risks identified from current conditions and
trends in selected portfolios, including management’s judgment
for imprecision and uncertainty. Also, we review individual
nonperforming loans over $3 million for impairment based
on cash flows or collateral. We include the impairment on
these nonperforming loans in the allowance unless it has
already been recognized as a loss.
The allowance includes an amount for imprecision or
uncertainty to incorporate the range of probable outcomes
inherent in estimates used for the allowance, which may
change from period to period. This portion of the total
allowance is the result of our judgment of risks inherent in
the portfolio, economic uncertainties, historical loss experi-
ence and other subjective factors, including industry trends.
In 2006, the methodology used to determine this portion of
the allowance was refined so that this method was calculated
for each portfolio type to better reflect our view of risk in
these portfolios. In prior years, this element of the allowance
was associated with the portfolio as a whole, rather than with
a specific portfolio type, and was categorized as unallocated.
The portion of the allowance representing our judgment
for imprecision or uncertainty may change from period to
period. The total allowance reflects management’s estimate
of credit losses inherent in the loan portfolio at the balance
sheet date.
To estimate the possible range of allowance required at
December 31, 2006, and the related change in provision
expense, we assumed the following scenarios of a reasonably
possible deterioration or improvement in loan credit quality.
Assumptions for deterioration in loan credit quality were:
• for consumer loans, an 18 basis point increase in esti-
mated loss rates from actual 2006 loss levels, moving
closer to longer term average loss rates; and
• for wholesale loans, a 30 basis point increase in esti-
mated loss rates, moving closer to historical averages.
Assumptions for improvement in loan credit quality were:
• for consumer loans, a 17 basis point decrease in
estimated loss rates from actual 2006 loss levels,
adjusting for the elevated auto losses and a better
economic environment for consumers; and
• for wholesale loans, nominal change from the
essentially zero 2006 net credit loss performance.
Under the assumptions for deterioration in loan credit
quality, another $546 million in expected losses could occur
and under the assumptions for improvement, a $339 million
reduction in expected losses could occur.
Changes in the estimate of the allowance for credit losses
and the related provision expense can materially affect net
income. The example above is only one of a number of
reasonably possible scenarios. Determining the allowance
for credit losses requires us to make forecasts of losses that
are highly uncertain and require a high degree of judgment.