TD Bank 2009 Annual Report Download - page 85

TD BANK FINANCIAL GROUP ANNUAL REPORT 2009 MANAGEMENT’S DISCUSSION AND ANALYSIS 81
The general allowance is recorded to provide against losses that are
considered to have occurred but that cannot yet be determined on an
item-by-item or group basis. In establishing the general allowance, the
Bank refers to internally developed models that utilize parameters for
PD, LGD, and EAD. These models calculate the probable range of general
allowance levels. Management judgment is used to determine the
point within the range that is the best estimate of losses, based on an
assessment of business and economic conditions, historical loss experi-
ence, loan portfolio composition, and other relevant indicators that are
not fully incorporated into the model calculation. If the wholesale and
commercial parameters were independently increased or decreased by
10%, then the model would indicate an increase or decrease to the
mean of the range in the amount or $11 million for PD, $11 million for
LGD, and $32 million for EAD, respectively. Changes in the general
allowance, if any, would primarily impact the Corporate and U.S.
Personal and Commercial Banking segments.
The “Managing Risk” – “Credit Risk” section of this MD&A provides
a more detailed discussion regarding credit risk. Also, see Note 3 to
the Bank’s Consolidated Financial Statements for additional disclosures
regarding the Bank’s allowance for credit losses.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of publicly traded financial instruments is based on quoted
market prices, adjusted for daily margin settlements, where applicable.
The fair value for a substantial majority of financial instruments is based
on quoted market prices or valuation models that use observable
market inputs. Observable market inputs include interest rate yield
curves, foreign exchange rates, and option volatilities. The valuation
models incorporate prevailing market rates and take into account
factors, such as counterparty credit quality, liquidity, and concentration
risk. When a market becomes inactive, broker quotes may not be an
appropriate primary source of valuation. In such cases the valuation is
based on a technique that maximizes the use of observable inputs.
Certain derivatives are valued using models with non-observable
market inputs, where the inputs estimated are subject to management’s
judgment. These derivatives are normally not actively traded and are
complex. For example, certain credit products are valued using models
with non-observable inputs such as correlation and recovery rates.
Uncertainty in estimating the inputs can impact the amount of revenue
or loss recorded for a particular position. Management’s judgment is
also used in recording fair value adjustments to model valuations to
account for measurement uncertainty when valuing complex and less
actively traded derivatives.
The Bank has controls in place to ensure that the valuations derived
from the models and inputs are appropriate. These include independent
review and approval of valuation models and inputs, and independent
review of the valuations by qualified personnel. As the market for
complex derivative products develops, the pricing for these products
may become more transparent, resulting in refinement of valuation
models. For a discussion of market risk, refer to the “Managing Risk” –
“Market Risk” section of this MD&A. As described in Note 30 to the
Consolidated Financial Statements, for financial instruments whose fair
value is estimated using valuation techniques based on non-observable
market inputs that are significant to the overall valuation, the difference
between the best estimate of fair value at initial recognition represented
by the transaction price, and the fair value determined using the valua-
tion technique, is recognized in income as the inputs become observable.
Note 30 also summarizes the difference between the transaction price
and amount determined at inception using valuation techniques with
significant non-observable market inputs.
The process for obtaining multiple quotes of external market prices,
consistent application of models over a period of time, and the controls
and processes described above, support the reasonability of the valua-
tion
models. The valuations are also validated by past experience and
through the actual cash settlement of contracts.
Valuation of private equity investments requires management’s
judgment due to the absence of quoted market prices, inherent lack
of liquidity, and the longer-term nature of such investments. Private
equity investments are recorded at cost and are compared with fair
value on a periodic basis to evaluate whether an impairment in value
has occurred that is other than temporary in nature. Fair value is
determined using valuation techniques, including discounted cash
flows and a multiple of earnings before taxes, depreciation, and amorti-
zation. Management applies judgment in the selection of the valuation
methodology and the various inputs to the calculation, which may vary
from one reporting period to another. These estimates are monitored
and reviewed on a regular basis by management for consistency and
reasonableness. Any imprecision in these estimates can affect the
resulting fair value. The inherent nature of private equity investing is
that management’s valuation will change over time as the underlying
investment matures and an exit strategy is developed and realized.
Estimates of fair value may also fluctuate due to developments in the
business underlying the investment. Such fluctuations may be signifi-
cant depending on the nature of the factors going into the valuation
methodology and the extent of change in those factors.
Available-for-sale securities are written down to their fair value
through the Consolidated Statement of Income when there is impair-
ment in value that is considered to be other than temporary in nature.
The determination of whether or not other than temporary impairment
exists is a matter of judgment. We review these securities regularly
for possible impairment that is other than temporary and this review
typically includes an analysis of the facts and circumstances of each
investment and the expectations for that investment’s performance.
Impairment of the value of an investment may be indicated by the
presence of conditions which should be examined collectively. For
equity securities, some of these conditions are prolonged periods
during which the fair value of the investment is significantly less than
its carrying value, significant financial difficulty of the issuer, severe
losses by the investee in the current year or current and prior years,
continued losses by the investee for a period of years, suspension
of trading in the securities, a downgrade of an entity’s credit rating,
or liquidity or going concern problems of the investee.
Debt securities classified as available-for-sale are considered impaired
when there is uncertainty concerning the collectability of interest and
principal. Accordingly, professional judgment is required in assessing
whether a decline in fair value is the result of a general reduction in
market liquidity, change in interest rates or due to collectability issues
with respect to the expected cash flows over the life of the debt security.
See Note 30 to the Bank’s Consolidated Financial Statements for
additional disclosures regarding the Bank’s significant financial assets
and financial liabilities carried at fair value by valuation methodology.
All of the Bank’s segments are impacted by this accounting policy.
The Bank recognizes interest income and expense using the effective
interest rate method for financial instruments that are accounted for
at amortized cost and for those that are classified as available-for-sale.
The effective interest rate is the rate that discounts the estimated
future cash flows over the expected life of the financial instrument
resulting in recognition of interest income and expense on a constant
yield basis.