Bank of America 2006 Annual Report Download - page 84

The more judgmental estimates are summarized below. We have
identified and described the development of the variables most important
in the estimation process that, with the exception of accrued taxes,
involve mathematical models to derive the estimates. In many cases,
there are numerous alternative judgments that could be used in the proc-
ess of determining the inputs to the model. Where alternatives exist, we
have used the factors that we believe represent the most reasonable
value in developing the inputs. Actual performance that differs from our
estimates of the key variables could impact Net Income. Separate from
the possible future impact to Net Income from input and model variables,
the value of our lending portfolio and market sensitive assets and
liabilities may change subsequent to the balance sheet measurement,
often significantly, due to the nature and magnitude of future credit and
market conditions. Such credit and market conditions may change quickly
and in unforeseen ways and the resulting volatility could have a significant,
negative effect on future operating results. These fluctuations would not
be indicative of deficiencies in our models or inputs.
Allowance for Credit Losses
The allowance for credit losses is our estimate of probable losses in the
loans and leases portfolio and within our unfunded lending commitments.
Changes to the allowance for credit losses are reported in the Con-
solidated Statement of Income in the Provision for Credit Losses. Our
process for determining the allowance for credit losses is discussed in the
Credit Risk Management section beginning on page 62 and Note 1 of the
Consolidated Financial Statements. Due to the variability in the drivers of
the assumptions made in this process, estimates of the portfolio’s
inherent risks and overall collectibility change with changes in the econo-
my, individual industries, countries and individual borrowers’ or counter-
parties’ ability and willingness to repay their obligations. The degree to
which any particular assumption affects the allowance for credit losses
depends on the severity of the change and its relationship to the other
assumptions.
Key judgments used in determining the allowance for credit losses
include: (i) risk ratings for pools of commercial loans and leases,
(ii) market and collateral values and discount rates for individually eval-
uated loans, (iii) product type classifications for consumer and commercial
loans and leases, (iv) loss rates used for consumer and commercial loans
and leases, (v) adjustments made to assess current events and con-
ditions, (vi) considerations regarding domestic and global economic
uncertainty, and (vii) overall credit conditions.
Our Allowance for Loan and Lease Losses is sensitive to the risk
rating assigned to commercial loans and leases. Assuming a downgrade
of one level in the internal risk rating for commercial loans and leases
rated under the internal risk rating scale, except loans and leases already
risk rated Doubtful as defined by regulatory authorities, the Allowance for
Loan and Lease Losses would increase by approximately $830 million at
December 31, 2006. The Allowance for Loan and Lease Losses as a
percentage of loan and lease outstandings at December 31, 2006 was
1.28 percent and this hypothetical increase in the allowance would raise
the ratio to approximately 1.39 percent. Our Allowance for Loan and Lease
Losses is also sensitive to the loss rates used for the consumer and
commercial portfolios. A 10 percent increase in the loss rates used on the
consumer and commercial loan and lease portfolios would increase the
Allowance for Loan and Lease Losses at December 31, 2006 by approx-
imately $610 million, of which $515 million would relate to consumer and
$95 million to commercial.
These sensitivity analyses do not represent management’s expect-
ations of the deterioration in risk ratings or the increases in loss rates but
are provided as hypothetical scenarios to assess the sensitivity of the
Allowance for Loan and Lease Losses to changes in key inputs. We
believe the risk ratings and loss severities currently in use are appropriate
and that the probability of a downgrade of one level of the internal risk
ratings for commercial loans and leases within a short period of time is
remote.
The process of determining the level of the allowance for credit
losses requires a high degree of judgment. It is possible that others, given
the same information, may at any point in time reach different reasonable
conclusions.
Fair Value of Financial Instruments
Trading Account Assets and Liabilities are recorded at fair value, which is
primarily based on actively traded markets where prices are based on
either direct market quotes or observed transactions. Liquidity is a sig-
nificant factor in the determination of the fair value of Trading Account
Assets or Liabilities. Market price quotes may not be readily available for
some positions, or positions within a market sector where trading activity
has slowed significantly or ceased. Situations of illiquidity generally are
triggered by the market’s perception of credit uncertainty regarding a sin-
gle company or a specific market sector. In these instances, fair value is
determined based on limited available market information and other fac-
tors, principally from reviewing the issuer’s financial statements and
changes in credit ratings made by one or more rating agencies. At
December 31, 2006, $8.4 billion, or six percent, of Trading Account
Assets were fair valued using these alternative approaches. An immaterial
amount of Trading Account Liabilities were fair valued using these alter-
native approaches at December 31, 2006.
The fair values of Derivative Assets and Liabilities include adjust-
ments for market liquidity, counterparty credit quality, future servicing
costs and other deal specific factors, where appropriate. To ensure the
prudent application of estimates and management judgment in determin-
ing the fair value of Derivative Assets and Liabilities, various processes
and controls have been adopted, which include: a Model Validation Policy
that requires a review and approval of quantitative models used for deal
pricing, financial statement fair value determination and risk quantifica-
tion; a Trading Product Valuation Policy that requires verification of all
traded product valuations; and a periodic review and substantiation of
daily profit and loss reporting for all traded products. These processes and
controls are performed independently of the business segments.
The fair values of Derivative Assets and Liabilities traded in the
over-the-counter market are determined using quantitative models that
require the use of multiple market inputs including interest rates, prices,
and indices to generate continuous yield or pricing curves and volatility
factors, which are used to value the position. The predominance of market
inputs are actively quoted and can be validated through external sources,
including brokers, market transactions and third- party pricing services.
Estimation risk is greater for derivative asset and liability positions that
are either option-based or have longer maturity dates where observable
market inputs are less readily available or are unobservable, in which case
quantitative based extrapolations of rate, price or index scenarios are
used in determining fair values. At December 31, 2006, the fair values of
Derivative Assets and Liabilities determined by these quantitative models
were $29.0 billion and $27.7 billion. These amounts reflect the full fair
value of the derivatives and do not isolate the discrete value associated
with the subjective valuation variable. Further, they represent 12.3 percent
and 12.2 percent of Derivative Assets and Liabilities, before the impact of
legally enforceable master netting agreements. For the year ended
December 31, 2006, there were no changes to the quantitative models, or
82 Bank of America 2006