Bank of America 2015 Annual Report Download - page 101

Bank of America 2015 99
Allowance for Credit Losses
The allowance for credit losses, which includes the allowance for
loan and lease losses and the reserve for unfunded lending
commitments, represents management’s estimate of probable
losses inherent in the Corporation’s loan portfolio excluding those
loans accounted for under the fair value option. Our process for
determining the allowance for credit losses is discussed in Note
1 – Summary of Significant Accounting Principles to the
Consolidated Financial Statements. We evaluate our allowance at
the portfolio segment level and our portfolio segments are
Consumer Real Estate, Credit Card and Other Consumer, and
Commercial. Due to the variability in the drivers of the assumptions
used in this 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 (e.g., the recent sharp
drop in oil prices), 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
Consumer Real Estate 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 Consumer Real Estate 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, 2015 would
have increased by $71 million. PCI loans within our Consumer Real
Estate 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 $151 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, 2015 would have increased by $38 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 $3.2 billion at December 31, 2015.
The allowance for loan and lease losses as a percentage of
total loans and leases at December 31, 2015 was 1.37 percent
and these hypothetical increases in the allowance would raise the
ratio to 1.75 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 FASB’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 primarily
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 $163 million in both MSRs
and mortgage banking income for 2015. 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 primarily recognized in
mortgage banking income. For additional information, see
Mortgage Banking Risk Management on page 97.