Wells Fargo 2010 Annual Report Download - page 86

Our significant accounting policies (see Note 1 (Summary of
Significant Accounting Policies) to Financial Statements in this
Report) are fundamental to understanding our results of
operations and financial condition because they require that we
use estimates and assumptions that may affect the value of our
assets or liabilities and financial results. Six of these policies are
critical because they require management 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:
Critical Accounting Policies
• the allowance for credit losses;
• purchased credit-impaired (PCI) loans;
• the valuation of residential mortgage servicing rights
(MSRs);
• liability for mortgage loan repurchase losses;
• the fair valuation of financial instruments; and
• income taxes.
Management has reviewed and approved these critical
accounting policies and has discussed these policies with the
Board’s Audit and Examination Committee.
Allowance for Credit Losses
The allowance for credit losses, which consists of the allowance
for loan losses and the allowance for unfunded credit
commitments, is management’s estimate of credit losses
inherent in the loan portfolio at the balance sheet date, excluding
loans carried at fair value. We develop and document our
allowance methodology at the portfolio segment level. Our loan
portfolio consists of a commercial loan portfolio segment and a
consumer loan portfolio segment.
We employ a disciplined process and methodology to
establish our allowance for credit losses. The total allowance for
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. No single statistic or measurement determines the
adequacy 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 rating for
each loan. In addition, the allowance for credit losses for
unfunded 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. As appropriate, we adjust or supplement these
loss factors and estimates to reflect other risks that may be
identified from current conditions and developments in selected
portfolios.
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 independent internal model validation group operating in
accordance with Company policies.
OTHER ACL MATTERS An allowance for impaired consumer and
commercial loans that have been modified in a TDR is measured
based on an estimate of cash flows, both principal and interest,
expected to be collected or an assessment of the fair value of
collateral underlying the impaired loan, if applicable.
Management exercises significant judgment to develop these
estimates.
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).
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.
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
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