Bank of America 2014 Annual Report Download - page 109

Bank of America 2014 107
process, estimates of the portfolio’s inherent risks and overall
collectability change with changes in the economy, individual
industries, countries, and borrowers’ 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 risk ratings for pools of commercial loans and
leases, market and collateral values and discount rates for
individually evaluated loans, product type classifications for
consumer and commercial loans and leases, loss rates used for
consumer and commercial loans and leases, adjustments made
to address current events and conditions, considerations
regarding domestic and global economic uncertainty, and overall
credit conditions.
Our estimate for the allowance for loan and lease losses is
sensitive to the loss rates and expected cash flows from our Home
Loans and Credit Card and Other Consumer portfolio segments,
as well as our U.S. small business commercial card portfolio within
the Commercial portfolio segment. For each one percent increase
in the loss rates on loans collectively evaluated for impairment in
our Home Loans portfolio segment, excluding PCI loans, coupled
with a one percent decrease in the discounted cash flows on those
loans individually evaluated for impairment within this portfolio
segment, the allowance for loan and lease losses at December 31,
2014 would have increased by $84 million. PCI loans within our
Home Loans portfolio segment are initially recorded at fair value.
Applicable accounting guidance prohibits carry-over or creation of
valuation allowances in the initial accounting. However,
subsequent decreases in the expected cash flows from the date
of acquisition result in a charge to the provision for credit losses
and a corresponding increase to the allowance for loan and lease
losses. We subject our PCI portfolio to stress scenarios to evaluate
the potential impact given certain events. A one percent decrease
in the expected cash flows could result in a $169 million
impairment of the portfolio. For each one percent increase in the
loss rates on loans collectively evaluated for impairment within
our Credit Card and Other Consumer portfolio segment and U.S.
small business commercial card portfolio, coupled with a one
percent decrease in the expected cash flows on those loans
individually evaluated for impairment within the Credit Card and
Other Consumer portfolio segment and the U.S. small business
commercial card portfolio, the allowance for loan and lease losses
at December 31, 2014 would have increased by $45 million.
Our allowance for loan and lease losses is sensitive to the risk
ratings assigned to loans and leases within the Commercial
portfolio segment (excluding the U.S. small business commercial
card portfolio). Assuming a downgrade of one level in the internal
risk ratings for commercial loans and leases, except loans and
leases already risk-rated Doubtful as defined by regulatory
authorities, the allowance for loan and lease losses would have
increased by $2.0 billion at December 31, 2014.
The allowance for loan and lease losses as a percentage of
total loans and leases at December 31, 2014 was 1.65 percent
and these hypothetical increases in the allowance would raise the
ratio to 1.90 percent.
These sensitivity analyses do not represent management’s
expectations 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 the alternative scenarios outlined above occurring 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.
For more information on the Financial Accounting Standards
Board’s proposed standard on accounting for credit losses, see
Note 1 – Summary of Significant Accounting Principles to the
Consolidated Financial Statements.
Mortgage Servicing Rights
MSRs are nonfinancial assets that are created when a mortgage
loan is sold and we retain the right to service the loan. We account
for consumer MSRs, including residential mortgage and home
equity MSRs, at fair value with changes in fair value recorded in
mortgage banking income in the Consolidated Statement of
Income.
We determine the fair value of our consumer MSRs using a
valuation model that calculates the present value of estimated
future net servicing income. The model incorporates key economic
assumptions including estimates of prepayment rates and
resultant weighted-average lives of the MSRs, and the option-
adjusted spread levels. These variables can, and generally do,
change from quarter to quarter as market conditions and projected
interest rates change. These assumptions are subjective in nature
and changes in these assumptions could materially affect our
operating results. For example, increasing the prepayment rate
assumption used in the valuation of our consumer MSRs by 10
percent while keeping all other assumptions unchanged could have
resulted in an estimated decrease of $208 million in both MSRs
and mortgage banking income for 2014. This impact does not
reflect any hedge strategies that may be undertaken to mitigate
such risk.
We manage potential changes in the fair value of MSRs through
a comprehensive risk management program. The intent is to
mitigate the effects of changes in the fair value of MSRs through
the use of risk management instruments. To reduce the sensitivity
of earnings to interest rate and market value fluctuations,
securities including MBS and U.S. Treasury securities, as well as
certain derivatives such as options and interest rate swaps, may
be used to hedge certain market risks of the MSRs, but are not
designated as accounting hedges. These instruments are carried
at fair value with changes in fair value recognized in mortgage
banking income. For additional information, see Mortgage Banking
Risk Management on page 105.
For more information on MSRs, including the sensitivity of
weighted-average lives and the fair value of MSRs to changes in
modeled assumptions, see Note 23 – Mortgage Servicing Rights
to the Consolidated Financial Statements.
Fair Value of Financial Instruments
We classify the fair values of financial instruments based on the
fair value hierarchy established under applicable accounting
guidance which requires an entity to maximize the use of
observable inputs and minimize the use of unobservable inputs
when measuring fair value. Applicable accounting guidance
establishes three levels of inputs used to measure fair value. We
carry trading account assets and liabilities, derivative assets and
liabilities, AFS debt and equity securities, other debt securities,