Wells Fargo 2011 Annual Report Download - page 92

Critical Accounting Policies (continued)
SENSITIVITY TO CHANGES
Changes in the allowance for credit
losses and, therefore, in the related provision expense can
materially affect net income. The establishment of the allowance
for credit losses relies on a consistent quarterly process that
requires significant management review and judgment.
Management considers changes in economic conditions,
customer behavior, and collateral value, among other influences.
From time to time, economic factors or business decisions, such
as the addition or liquidation of a loan product or business unit,
may affect the loan portfolio, causing management to provide or
release amounts from the allowance for credit losses.
The allowance for credit losses for commercial loans,
including unfunded credit commitments (individually risk
weighted) is sensitive to credit risk ratings assigned to each
credit exposure. Commercial loan risk ratings are evaluated
based on each situation by experienced senior credit officers and
are subject to periodic review by an independent internal team of
credit specialists.
The allowance for credit losses for consumer loans
(statistically modeled) is sensitive to economic assumptions and
delinquency trends. Forecasted losses are modeled using a range
of economic scenarios.
Assuming a one risk rating downgrade throughout our
commercial portfolio segment, a more pessimistic economic
outlook for modeled losses on our consumer portfolio segment
and incremental deterioration in our PCI portfolio could imply
an additional allowance requirement of approximately
$11.0 billion.
Assuming a one risk rating upgrade throughout our
commercial portfolio segment and a more optimistic economic
outlook for modeled losses on our consumer portfolio segment
could imply a reduced allowance requirement of approximately
$3.1 billion.
The sensitivity analyses provided are hypothetical scenarios
and are not considered probable. They do not represent
management’s view of inherent losses in the portfolio as of the
balance sheet date. Because significant judgment is used, it is
possible that others performing similar analyses could reach
different conclusions.
See the “Risk Management – Credit Risk Management”
section and Note 6 (Loans and Allowance for Credit Losses) to
Financial Statements in this Report for further discussion of our
allowance.
Purchased Credit-Impaired (PCI) Loans
Loans acquired with evidence of credit deterioration since their
origination and where it is probable that we will not collect all
contractually required principal and interest payments are
accounted for using the measurement provision for PCI loans.
PCI loans are recorded at fair value at the date of acquisition, and
the historical allowance for credit losses related to these loans is
not carried over. Such loans are considered to be accruing due to
the existence of the accretable yield and not based on
consideration given to contractual interest payments.
Substantially all of our PCI loans were acquired in the Wachovia
acquisition on December 31, 2008.
Management evaluated whether there was evidence of credit
quality deterioration as of the purchase date using indicators
such as past due and nonaccrual status, commercial risk ratings,
recent borrower credit scores and recent loan-to-value
percentages.
The fair value at acquisition was based on an estimate of cash
flows, both principal and interest, expected to be collected,
discounted at the prevailing market rate of interest. We
estimated the cash flows expected to be collected at acquisition
using our internal credit risk, interest rate risk and prepayment
risk models, which incorporate our best estimate of current key
assumptions, such as property values, default rates, loss severity
and prepayment speeds.
Substantially all commercial and industrial, CRE and foreign
PCI loans are accounted for as individual loans. Conversely, Pick-
a-Pay and other consumer PCI loans have been aggregated into
several pools based on common risk characteristics. Each pool is
accounted for as a single asset with a single composite interest
rate and an aggregate expectation of cash flows.
The excess of cash flows expected to be collected over the
carrying value (estimated fair value at acquisition date) is
referred to as the accretable yield and is recognized in interest
income using an effective yield method over the remaining life of
the loan, or pool of loans, in situations where there is a
reasonable expectation about the timing and amount of cash
flows expected to be collected. The difference between the
contractually required payments and the cash flows expected to
be collected at acquisition, considering the impact of
prepayments, is referred to as the nonaccretable difference.
Subsequent to acquisition, we regularly evaluate our estimates
of cash flows expected to be collected. These evaluations,
performed quarterly, require the continued usage of key
assumptions and estimates, similar to our initial estimate of fair
value. We must apply judgment to develop our estimates of cash
flows for PCI loans given the impact of home price and property
value changes, changing loss severities, modification activity, and
prepayment speeds.
If we have probable decreases in cash flows expected to be
collected (other than due to decreases in interest rate indices and
changes in prepayment assumptions), we charge the provision
for credit losses, resulting in an increase to the allowance for loan
losses. If we have probable and significant increases in cash flows
expected to be collected, we first reverse any previously
established allowance for loan losses and then increase interest
income as a prospective yield adjustment over the remaining life
of the loan, or pool of loans. Estimates of cash flows are impacted
by changes in interest rate indices for variable rate loans and
prepayment assumptions, both of which are treated as
prospective yield adjustments included in interest income.
Resolutions of loans may include sales of loans to third
parties, receipt of payments in settlement with the borrower, or
foreclosure of the collateral. Our policy is to remove an
individual loan from a pool based on comparing the amount
received from its resolution with its contractual amount. Any
difference between these amounts is absorbed by the
nonaccretable difference for the entire pool. This removal
method assumes that the amount received from resolution
approximates pool performance expectations. The remaining
accretable yield balance is unaffected and any material change in
remaining effective yield caused by this removal method is
90