Wells Fargo 2005 Annual Report Download - page 109

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Our approach to managing interest rate risk includes the
use of derivatives. This helps minimize significant, unplanned
fluctuations in earnings, fair values of assets and liabilities,
and cash flows caused by interest rate volatility. This
approach involves modifying the repricing characteristics of
certain assets and liabilities so that changes in interest rates
do not have a significant adverse effect on the net interest
margin and cash flows. As a result of interest rate fluctuations,
hedged assets and liabilities will gain or lose market value.
In a fair value hedging strategy, the effect of this unrealized
gain or loss will generally be offset by income or loss on the
derivatives linked to the hedged assets and liabilities. In a
cash flow hedging strategy, we manage the variability of
cash payments due to interest rate fluctuations by the effective
use of derivatives linked to hedged assets and liabilities.
We use derivatives as part of our interest rate risk
management, including interest rate swaps, caps and floors,
futures and forward contracts, and options. We also offer
various derivatives, including interest rate, commodity,
equity, credit and foreign exchange contracts, to our customers
but usually offset our exposure from such contracts by
purchasing other financial contracts. The customer accom-
modations and any offsetting financial contracts are treated
as free-standing derivatives. Free-standing derivatives also
include derivatives we enter into for risk management that
do not otherwise qualify for hedge accounting. To a lesser
extent, we take positions based on market expectations
or to benefit from price differentials between financial
instruments and markets.
By using derivatives, we are exposed to credit risk if
counterparties to financial instruments do not perform as
expected. If a counterparty fails to perform, our credit risk
is equal to the fair value gain in a derivative contract. We
minimize credit risk through credit approvals, limits and
monitoring procedures. Credit risk related to derivatives is
considered and, if material, provided for separately. As we
generally enter into transactions only with counterparties
that carry high quality credit ratings, losses from counterparty
nonperformance on derivatives have not been significant.
Further, we obtain collateral, where appropriate, to reduce
risk. To the extent the master netting arrangements meet the
requirements of FASB Interpretation No. 39, Offsetting of
Amounts Related to Certain Contracts, as amended by
FASB Interpretation No. 41, Offsetting of Amounts Related
to Certain Repurchase and Reverse Repurchase Agreements,
amounts are shown net in the balance sheet.
Our derivative activities are monitored by the Corporate
Asset/Liability Management Committee. Our Treasury
function, which includes asset/liability management, is
responsible for various hedging strategies developed
through analysis of data from financial models and other
internal and industry sources. We incorporate the resulting
hedging strategies into our overall interest rate risk
management and trading strategies.
Fair Value Hedges
We use derivatives, such as interest rate swaps, swaptions,
Treasury futures and options, Eurodollar futures and options,
and forward contracts, to manage the risk of changes in the
fair value of MSRs and other retained interests. Derivative
gains or losses caused by market conditions (volatility) and
the spread between spot and forward rates priced into the
derivative contracts (the passage of time) are excluded from
the evaluation of hedge effectiveness, but are reflected in
earnings. Net derivative gains and losses related to our
mortgage servicing activities are included in “Servicing
income, net” in Note 21.
We use derivatives, such as Treasury and LIBOR futures
and swaptions, to hedge changes in fair value due to changes
in interest rates of our commercial real estate mortgages and
franchise loans held for sale. The ineffective portion of these
fair value hedges is recorded as part of mortgage banking
noninterest income in the income statement. We also enter
into interest rate swaps, designated as fair value hedges, to
convert certain of our fixed-rate long-term debt to floating-
rate debt. In addition, we enter into cross-currency swaps
and cross-currency interest rate swaps to hedge our exposure
to foreign currency risk and interest rate risk associated
with the issuance of non-U.S. dollar denominated debt.
For commercial real estate, long-term debt and foreign
currency hedges, all parts of each derivative’s gain or loss
are included in the assessment of hedge effectiveness.
At December 31, 2005, all designated fair value hedges
continued to qualify as fair value hedges.
Note 26: Derivatives
Management believes that, as of December 31, 2005, the
Company and each of the covered subsidiary banks met all
capital adequacy requirements to which they are subject.
The most recent notification from the OCC categorized
each of the covered subsidiary banks as well capitalized,
under the FDICIA prompt corrective action provisions
applicable to banks. To be categorized as well capitalized,
the institution must maintain a total risk-based capital ratio
as set forth in the table on the previous page and not be
subject to a capital directive order. There are no conditions
or events since that notification that management believes
have changed the risk-based capital category of any of the
covered subsidiary banks.
As an approved seller/servicer, Wells Fargo Bank, N.A.,
through its mortgage banking division, is required to maintain
minimum levels of shareholders’ equity, as specified by various
agencies, including the United States Department of Housing
and Urban Development, Government National Mortgage
Association, Federal Home Loan Mortgage Corporation and
Federal National Mortgage Association. At December 31,
2005, Wells Fargo Bank, N.A. met these requirements.