Wells Fargo 2013 Annual Report Download - page 110

Critical Accounting Policies (continued)
credit losses considers both impaired and unimpaired loans.
While our methodology attributes portions of the allowance to
specific portfolio segments, the entire allowance for credit losses
is available to absorb credit losses inherent in the total loan
portfolio and unfunded credit commitments. No single statistic
or measurement determines the appropriateness of the
allowance for credit losses.
COMMERCIAL PORTFOLIO SEGMENT The allowance for
credit losses for unimpaired commercial loans is estimated
through the application of loss factors to loans based on credit
risk ratings for each loan. In addition, the allowance for
unfunded credit commitments, including letters of credit, is
estimated by applying these loss factors to loan equivalent
exposures. The loss factors reflect the estimated default
probability and quality of the underlying collateral. The loss
factors used are statistically derived through the observation of
historical losses incurred for loans within each credit risk rating
over a relevant specified period of time. We apply our judgment
to adjust or supplement these loss factors and estimates to reflect
other risks that may be identified from current conditions and
developments in selected portfolios. These risk ratings are
subject to review by an internal team of credit specialists.
The allowance also includes an amount for estimated credit
losses on impaired loans such as nonaccrual loans and loans that
have been modified in a TDR, whether on accrual or nonaccrual
status.
CONSUMER PORTFOLIO SEGMENT Loans are pooled
generally by product type with similar risk characteristics. Losses
are estimated using forecasted losses to represent our best
estimate of inherent loss based on historical experience,
quantitative and other mathematical techniques over the loss
emergence period. Each business group exercises significant
judgment in the determination of the credit loss estimation
model that fits the credit risk characteristics of its portfolio. We
use both internally developed and vendor supplied models in this
process. We often use roll rate or net flow models for near-term
loss projections, and vintage-based models, behavior score
models, and time series or statistical trend models for longer-
term projections. Management must use judgment in
establishing additional input metrics for the modeling processes,
considering further stratification into sub-product, origination
channel, vintage, loss type, geographic location and other
predictive characteristics. In addition, we establish an allowance
for consumer loans modified in a TDR, whether on accrual or
nonaccrual status.
The models used to determine the allowance are validated by
an internal model validation group operating in accordance with
Company policies.
OTHER ACL MATTERS The allowance for credit losses for both
portfolio segments includes an amount for imprecision or
uncertainty that may change from period to period. This amount
represents management’s judgment of risks inherent in the
processes and assumptions used in establishing the allowance.
This imprecision considers economic environmental factors,
modeling assumptions and performance, process risk, and other
subjective factors, including industry trends and risk
assessments for our commitments to regulatory and government
agencies regarding settlements of mortgage foreclosure-related
matters.
Impaired loans, which predominantly include nonaccrual
commercial loans and any loans that have been modified in a
TDR have an estimated allowance calculated as the difference, if
any, between the impaired value of the loan and the recorded
investment in the loan. The impaired value of the loan is
generally calculated as the present value of expected future cash
flows from principal and interest, which incorporates expected
lifetime losses, discounted at the loan’s effective interest rate.
The development of these expectations requires significant
management review and judgment. When collateral is the sole
source of repayment for an impaired loan, rather than the
borrower’s income or other sources of repayment, we charge
down to net realizable value which may reduce or eliminate the
need for an allowance. The allowance for an unimpaired loan is
based solely on principal losses without consideration for timing
of those losses. The allowance for an impaired loan that was
modified in a TDR may be lower than the previously established
allowance for that loan due to benefits received through
modification, such as lower probability of default and/or severity
of loss, and the impact of prior charge-offs or charge-offs at the
time of the modification that may reduce or eliminate the need
for an allowance.
Commercial and consumer PCI loans may require an
allowance subsequent to their acquisition. This allowance
requirement is due to probable decreases in expected principal
and interest cash flows (other than due to decreases in interest
rate indices and changes in prepayment assumptions).
SENSITIVITY TO CHANGES Changes in the allowance for credit
losses and, therefore, in the related provision for credit losses
can materially affect net income. In applying the review and
judgment required to determine the allowance for credit losses,
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 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
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