2004 Annual Report: Financial Review: Statements and Notes: Note 8 Special Purpose Financing Entities

Note 8

Special Purpose Financing Entities

The Corporation securitizes assets and may retain a portion or all of the securities, subordinated tranches, interest-only strips and, in some cases, a cash reserve account, all of which are considered retained interests in the securitized assets. Those assets may be serviced by the Corporation or by third parties. The Corporation also uses other special purpose financing entities to access the commercial paper market and for other lending, leasing and real estate activities. See Note 1 of the Consolidated Financial Statements for a more detailed discussion of securitizations and other special purpose financing entities.

Mortgage-related Securitizations

The Corporation securitizes the majority of its residential mortgage loan originations in conjunction with or shortly after loan closing. In addition, the Corporation may, from time to time, securitize commercial mortgages and first residential mortgages that it originates or purchases from other entities. In 2004 and 2003, the Corporation converted a total of $96.9 billion (including $18.0 billion originated by other entities) and $121.1 billion (including $13.0 billion originated by other entities), respectively, of residential first mortgages and commercial mortgages into mortgage-backed securities issued through Fannie Mae, Freddie Mac, Government National Mortgage Association (Ginnie Mae), Bank of America, N.A. and Banc of America Mortgage Securities. At December 31, 2004 and 2003, the Corporation retained $9.2 billion (including $1.2 billion issued prior to 2004) and $1.7 billion of securities, respectively. At December 31, 2004, these retained interests were valued using quoted market prices.

For 2004, the Corporation reported $952 million in gains on loans converted into securities and sold, of which $886 million was from loans originated by the Corporation and $66 million was from loans originated by other entities. For 2003, the Corporation reported $2.4 billion in gains on loans converted into securities and sold, of which $2.0 billion was from loans originated by the Corporation and $381 million was from loans originated by other entities. At December 31, 2004, the Corporation had recourse obligations of $558 million with varying terms up to seven years on loans that had been securitized and sold.

In addition to the retained interests in the securities, the Corporation has retained MSRs from the sale or securitization of residential mortgage loans. Servicing fee and ancillary fee income on all loans serviced, including securitizations, was $568 million and $314 million in 2004 and 2003, respectively. The activity in MSRs for 2004 and 2003 is as follows:

(Dollars in millions)	2004		2003
Balance, January 1	$  479		$ 499
Additions (1)	3,036		201
Amortization	(360)		(145)
Change in value attributed to SFAS 133 hedged MSRs (2)	(210)		-
Impairment, net of recoveries	(463)		(76)
Balance, December 31 (3,4)	$2,482		$ 479
(1) Includes $2.2 billion of Certificates converted to MSRs on June 1, 2004. (2) Excludes $228 of offsetting derivative hedge gains recognized in Mortgage Banking Income for 2004. (3) Net of impairment allowance of $361 for 2004. (4) 2003 does not include $2.3 billion of Certificates.

The estimated fair value of MSRs was $2.5 billion and $479 million at December 31, 2004 and 2003, respectively. The additions during 2004 included $2.2 billion of MSRs as a result of the conversion of Certificates discussed in Note 1 of the Consolidated Financial Statements.

The key economic assumptions used in valuations of MSRs include modeled prepayment rates and resultant expected weighted average lives of the MSRs and the option adjusted spread (OAS) levels. An OAS model runs multiple interest rate scenarios and projects prepayments specific to each one of those interest rate scenarios.

As of December 31, 2004, the modeled weighted average lives of MSRs related to fixed and adjustable rate loans (including hybrid ARMs) were 4.65 years and 3.02 years, respectively. A decrease of 10 and 20 percent in modeled prepayments would extend the expected weighted average lives for MSRs related to fixed rate loans to 5.01 years and 5.40 years, respectively, and would extend the expected weighted average lives for MSRs related to adjustable rate loans to 3.32 years and 3.68 years, respectively. The expected extension of weighted average lives would increase the value of MSRs by a range of $143 million to $295 million. An increase of 10 and 20 percent in modeled prepayments would reduce the expected weighted average lives for MSRs related to fixed rate loans to 4.38 years and 4.11 years, respectively, and would reduce the expected weighted average lives for MSRs related to adjustable rate loans to 2.78 years and 2.57 years, respectively. The expected reduction of weighted average lives would decrease the value of MSRs by a range of $112 million to $219 million. A decrease of 100 and 200 basis points (bps) in the OAS level would result in an increase in the value of MSRs ranging from $89 million to $185 million, and an increase of 100 and 200 bps in the OAS level would result in a decrease in the value of MSRs ranging from $83 million to $160 million.

For purposes of evaluating and measuring impairment, the Corporation stratifies the portfolio based on the predominant risk characteristics of loan type and note rate. Indicated impairment, by risk stratification, is recognized as a reduction in Mortgage Banking Income, through a valuation allowance, for any excess of adjusted carrying value over estimated fair value. Impairment, net of recoveries of MSRs totaled $463 million for 2004. For 2003, changes in the value of the Certificates and MSRs were recognized as Trading Account Profits. Impairment charges in 2004 included changes to valuation assumptions and prepayment adjustments related to expectations regarding future prepayment speeds and other assumptions totaling $261 million. Additional impairment reflects decreases in the value of MSRs primarily due to increased probability of prepayments driven by decreases in market interest rates during the second half of 2004.

Other Securitizations

As a result of the Merger, the Corporation acquired an interest in several credit card, home equity loan and commercial loan securitization vehicles, which had aggregate debt securities outstanding of $10.3 billion as of December 31, 2004. During 2004, the Corporation securitized $2.0 billion of automobile loans and retained $1.7 billion of the AAA securities, which are held in the AFS securities portfolio.

At December 31, 2004 and 2003, investment grade securities of $2.9 billion and $2.1 billion, respectively, which are valued using quoted market prices remained in the AFS securities portfolio. At December 31, 2004 there were no recognized servicing assets associated with these securitization transactions.

The Corporation has provided protection on a subset of one consumer finance securitization in the form of a guarantee with a maximum payment of $220 million that will only be paid if over-collateralization is not sufficient to absorb losses and certain other conditions are met. The Corporation projects no payments will be due over the life of the contract, which is approximately one year.

Key economic assumptions used in measuring the fair value of certain residual interests (included in Other Assets) in securitizations and the sensitivity of the current fair value of residual cash flows to changes in those assumptions are as follows:

	Credit Card 2004	Credit Card 2003	Subprime Consumer Finance 2004(1)	Subprime Consumer Finance 2003(1)	Automobile Loans 2004	Home Equity Lines 2004	Commercial Loans 2004
	Credit Card		Subprime Consumer Finance (1)		Automobile Loans	Home Equity Lines	Commercial Loans
(Dollars in millions)	2004	2003	2004	2003	2004	2004	2004
Carrying amount of residual interests (at fair value) (2)	$  349	$   76	$  313	328	$   34	$ 17	$  130
Balance of unamortized securitized loans	6,903	1,782	5,886	9,409	1,644	630	3,337
Weighted average life to call (in years) (3)	1.2	1.4	1.3	1.6	1.4	1.3	n/a
Revolving structures - annual payment rate	13.7 %	14.9 %				45.0 %	4.5 %(4)
Amortizing structures - annual constant prepayment rate:
Fixed rate loans			7.5-32.7 %	7.8-32.6 %	24.9 %
Adjustable rate loans			27.0-40.8	27.0-42.4	-
Impact on fair value of 100 bps favorable change	$    1	$    -	$    1	$    4	$    -	$  -	$    2
Impact on fair value of 200 bps favorable change	2	-	11	11	-	1	2
Impact on fair value of 100 bps adverse change	(1)	-	(9)	(11)	-	-	(1)
Impact on fair value of 200 bps adverse change	(2)	-	(17)	(15)	(1)	(1)	(1)
Expected credit losses (5)	5.3-9.7 %	5.3 %	5.1-12.3 %	4.6-11.0 %	1.6 %	0.2 %	0.4 %
Impact on fair value of 10% favorable change	$   18	$    2	$   27	$   37	$    3	$  -	$    1
Impact on fair value of 25% favorable change	47	5	71	100	6	-	2
Impact on fair value of 10% adverse change	(15)	(2)	(27)	(37)	(2)	-	(1)
Impact on fair value of 25% adverse change	(27)	(5)	(68)	(82)	(6)	-	(2)
Residual cash flows discount rate (annual rate)	6.0-12.0 %	6.0 %	15.0-30.0 %	15.0-30.0 %	20.0 %	12.0 %	12.3 %
Impact on fair value of 100 bps favorable change	$    -	$    -	$    6	$    8	$    1	$  -	$    1
Impact on fair value of 200 bps favorable change	-	-	12	16	1	-	2
Impact on fair value of 100 bps adverse change	-	-	(6)	(8)	(1)	-	(1)
Impact on fair value of 200 bps adverse change	-	-	(12)	(15)	(1)	-	(2)
(1) Subprime consumer finance includes subprime real estate loan and manufactured housing loan securitizations, which are all serviced by third parties. (2) Residual interests include interest-only strips, one or more subordinated tranches, accrued interest receivable, and in some cases, a cash reserve account. (3) Before any optional clean-up calls are executed, economic analyses will be performed. (4) Monthly average net pay rate (pay rate less draw rate). (5) Annual rates of expected credit losses are presented for credit card, home equity lines and commercial securitizations. Cumulative lifetime rates of expected credit losses (incurred plus projected) are presented for subprime consumer finance securitizations and the auto securitizations. n/a = not applicable

The sensitivities in the preceding table are hypothetical and should be used with caution. As the amounts indicate, changes in fair value based on variations in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Additionally, the Corporation has the ability to hedge interest rate risk associated with retained residual positions. The above sensitivities do not reflect any hedge strategies that may be undertaken to mitigate such risk.

Static pool net credit losses are considered in determining the value of retained interests. Static pool net credit losses include actual losses incurred plus projected credit losses divided by the original balance of each securitization pool. Expected static pool net credit losses at December 31, 2004 for the 2004 auto loan securitization were 1.63 percent. For the subprime consumer finance securitizations, weighted average static pool net credit losses for 2001, 1999, 1998, 1997 and 1995 were 5.93 percent, 11.67 percent, 9.20 percent, 4.92 percent and 12.25 percent, respectively at December 31, 2004, and 5.83 percent, 9.91 percent, 8.22 percent, 4.92 percent and 10.83 percent, respectively, at December 31, 2003.

Proceeds from collections reinvested in revolving credit card securitizations were $6.8 billion and $3.8 billion in 2004 and 2003, respectively. Credit card servicing fee income totaled $134 million and $51 million in 2004 and 2003, respectively.  Other cash flows received on retained interests, such as cash flows from interest-only strips, were $345 million and $279 million in 2004 and 2003, respectively, for credit card securitizations. Proceeds from collections reinvested in revolving commercial loan securitizations were $1.1 billion in 2004. Servicing fees and other cash flows received on retained interests, such as cash flows from interest-only strips, were $4 million and $11 million, respectively, in 2004 for commercial loan securitizations.

The Corporation reviews its loans and leases portfolio on a managed basis. Managed loans and leases are defined as on-balance sheet Loans and Leases as well as loans in revolving securitizations, which include credit cards, home equity lines and commercial loans. New advances under previously securitized accounts will be recorded on the Corporation’s Consolidated Balance Sheet after the revolving period of the securitization, which has the effect of increasing Loans and Leases on the Corporation’s Consolidated Balance Sheet and increasing Net Interest Income and charge-offs, with a corresponding reduction in Noninterest Income. Portfolio balances, delinquency and historical loss amounts of the managed loans and leases portfolio for 2004 and 2003 were as follows:

	December 31, 2004: Total Principal Amount of Loans and Leases	December 31, 2004: Principal Amount of Accruing Loans and Leases Past Due 90 Days or More	December 31, 2004: Principal Amount of Nonperforming Loans and Leases		December 31, 2003: Total Principal Amount of Loans and Leases	December 31, 2003: Principal Amount of Accruing Loans and Leases Past Due 90 Days or More	December 31, 2003: Principal Amount of Nonperforming Loans and Leases
	December 31, 2004				December 31, 2003
(Dollars in millions)	Total Principal Amount of Loans and Leases	Principal Amount of Accruing Loans and Leases Past Due 90 Days or More (1)	Principal Amount of Nonperforming Loans and Leases		Total Principal Amount of Loans and Leases	Principal Amount of Accruing Loans and Leases Past Due 90 Days or More (1)	Principal Amount of Nonperforming Loans and Leases
Residential mortgage	$178,103	$    -	554		$140,513	$  -	531
Credit card	58,629	1,223	-		36,596	647	-
Home equity lines	50,756	3	66		23,859	-	43
Direct/Indirect consumer	40,513	58	33		33,415	47	28
Other consumer	7,439	23	85		7,558	35	36
Total consumer	335,440	1,307	738		241,941	729	638
Commercial - domestic	125,432	121	855		91,491	108	1,388
Commercial real estate	32,319	1	87		19,367	23	141
Commercial lease financing	21,115	14	266		9,692	2	127
Commercial - foreign	18,401	2	267		10,754	29	578
Total commercial	197,267	138	1,475		131,304	162	2,234
Total managed loans and leases	532,707	$1,445	$2,213		373,245	$891	$2,872
Loans in revolving securitizations	(10,870)				(1,782)
Total held loans and leases	$521,837				$371,463
	Year Ended December 31, 2004: Average Loans and Leases Outstanding	Year Ended December 31, 2004: Loans and Leases Net Losses	Year Ended December 31, 2004: Net Loss Ratio(2)		Year Ended December 31, 2003: Average Loans and Leases Outstanding	Year Ended December 31, 2003: Loans and Leases Net Losses	Year Ended December 31, 2003: Net Loss Ratio(2)
	Year Ended December 31, 2004				Year Ended December 31, 2003
(Dollars in millions)	Average Loans and Leases Outstanding	Loans and Leases Net Losses	Net Loss Ratio (2)		Average Loans and Leases Outstanding	Loans and Leases Net Losses	Net Loss Ratio (2)
Residential mortgage	$167,298	$   36	0.02 %		$127,059	$   40	0.03%
Credit card	50,296	2,829	5.62		31,552	1,691	5.36
Home equity lines	39,942	15	0.04		22,890	11	0.05
Direct/Indirect consumer	38,078	208	0.55		32,593	181	0.55
Other consumer	7,717	193	2.50		8,865	256	2.89
Total consumer	303,331	3,281	1.08		222,959	2,179	0.98
Commercial - domestic	117,422	184	0.16		93,458	633	0.68
Commercial real estate	28,085	(3)	(0.01)		20,042	41	0.20
Commercial lease financing	17,483	9	0.05		10,061	124	1.23
Commercial - foreign	16,505	173	1.05		12,970	306	2.36
Total commercial	179,495	363	0.20		136,531	1,104	0.81
Total managed loans and leases	482,826	$3,644	0.75 %		359,490	$3,283	0.91%
Loans in revolving securitizations	(10,181)				(3,342)
Total held loans and leases	$472,645				$356,148
(1) Excludes consumer real estate loans, which are placed on nonperforming status at 90 days past due. (2) The net loss ratio is calculated by dividing managed loans and leases net losses by average managed loans and leases outstanding for each loan and lease category.

Variable Interest Entities

At December 31, 2004, the assets and liabilities of ABCP conduits that have been consolidated in accordance with FIN 46 were reflected in AFS Securities, Other Assets, and Commercial Paper and Other Short-term Borrowings in the Global Capital Markets and Investment Banking business segment. As of December 31, 2004 and 2003, the Corporation held $7.7 billion and $5.6 billion of assets in these entities, respectively, while the Corporation’s maximum loss exposure associated with these entities including unfunded lending commitments was approximately $9.4 billion and $7.6 billion, respectively. The Corporation also had contractual relationships with other consolidated VIEs that engage in leasing or lending activities or real estate joint ventures. As of December 31, 2004 and 2003, the amount of assets of these entities was $560 million and $382 million, respectively, and the Corporation’s maximum possible loss exposure was $132 million and $131 million, respectively.

Additionally, the Corporation had significant variable interests in other VIEs that it did not consolidate because it was not deemed to be the primary beneficiary. In such cases, the Corporation does not absorb the majority of the entities’ expected losses nor does it receive a majority of the entities’ expected residual returns, or both. These entities typically support the financing needs of the Corporation’s customers by facilitating their access to the commercial paper markets. The Corporation functions as administrator and provides either liquidity and letters of credit, or derivatives to the VIE. The Corporation also provides asset management and related services to other special purpose vehicles that engage in lending, investing, or real estate activities. Total assets of these entities at December 31, 2004 and 2003 were approximately $32.9 billion and $28.0 billion, respectively; revenues associated with administration, liquidity, letters of credit and other services were approximately $154 million in 2004 and $94 million in 2003. At December 31, 2004 and 2003, the Corporation’s maximum loss exposure associated with these VIEs was approximately $25.0 billion and $21.7 billion, respectively, which is net of amounts syndicated.

Management does not believe losses resulting from its involvement with the entities discussed above will be material. See Note 1 of the Consolidated Financial Statements for additional discussion of special purpose financing entities.