Wells Fargo 2005 Annual Report Download - page 110

108
Cash Flow Hedges
We hedge floating-rate senior debt against future interest
rate increases by using interest rate swaps to convert floating-
rate senior debt to fixed rates and by using interest rate caps
and floors to limit variability of rates. We also use derivatives,
such as Treasury futures, forwards and options, Eurodollar
futures, and forward contracts, to hedge forecasted sales
of mortgage loans. Gains and losses on derivatives that are
reclassified from cumulative other comprehensive income
to current period earnings, are included in the line item
in which the hedged item’s effect in earnings is recorded.
All parts of gain or loss on these derivatives are included
in the assessment of hedge effectiveness. As of December 31,
2005, all designated cash flow hedges continued to qualify
as cash flow hedges.
At December 31, 2005, we expected that $13 million of
deferred net losses on derivatives in other comprehensive
income will be reclassified as earnings during the next twelve
months, compared with $8 million and $9 million of deferred
net losses at December 31, 2004 and 2003, respectively.
We are hedging our exposure to the variability of future
cash flows for all forecasted transactions for a maximum
of one year for hedges converting floating-rate loans to fixed
rates, 10 years for hedges of floating-rate senior debt and
one year for hedges of forecasted sales of mortgage loans.
The following table provides derivative gains and losses
related to fair value and cash flow hedges resulting from
the change in value of the derivatives excluded from the
assessment of hedge effectiveness and the change in value
of the ineffective portion of the derivatives.
(in millions) December 31,
2005 2004 2003
Gains (losses) from derivatives related to MSRs
and other retained interests from change in value of:
Derivatives excluded from the assessment of
hedge effectiveness $ 338 $ 944 $ 908
Ineffective portion of derivatives (384)(390) 203
Net derivative gains (losses) related to MSRs
and other retained interests $ (46) $ 554 $1,111
Losses from ineffective portion of change in
the value of other fair value hedges (1) $ (15) $ (21) $ (22)
Gains from ineffective portion of change in
the value of cash flow hedges $23 $ 10 $ 72
(1) Includes commercial real estate, long-term debt and foreign currency.
Free-Standing Derivatives
We enter into various derivatives primarily to provide
derivative products to customers. To a lesser extent, we
take positions based on market expectations or to benefit
from price differentials between financial instruments and
markets. These derivatives are not linked to specific assets
and liabilities on the balance sheet or to forecasted transactions
in an accounting hedge relationship and, therefore, do not
qualify for hedge accounting. We also enter into free-standing
derivatives for risk management that do not otherwise qualify
for hedge accounting. They are carried at fair value with
changes in fair value recorded as part of other noninterest
income in the income statement.
Interest rate lock commitments for residential mortgage
loans that we intend to resell are considered free-standing
derivatives. Our interest rate exposure on these derivative
loan commitments is economically hedged with Treasury
futures, forwards and options, Eurodollar futures, and
forward contracts. The commitments and free-standing
derivatives are carried at fair value with changes in fair
value recorded as a part of mortgage banking noninterest
income in the income statement. We record a zero fair value
for a derivative loan commitment at inception consistent
with EITF 02-3, Issues Involved in Accounting for Derivative
Contracts Held for Trading Purposes and Contracts
Involved in Energy Trading and Risk Management Activities,
and Securities and Exchange Commission (SEC) Staff
Accounting Bulletin No. 105, Application of Accounting
Principles to Loan Commitments. Changes subsequent to
inception are based on changes in fair value of the underlying
loan resulting from the exercise of the commitment and
changes in the probability that the loan will fund within the
terms of the commitment, which is affected primarily by
changes in interest rates and passage of time. The aggregate
fair value of derivative loan commitments on the consolidated
balance sheet at December 31, 2005 and 2004, was a net
liability of $54 million and $38 million, respectively; and
is included in the caption “Interest rate contracts – Options
written” under Customer Accommodations and Trading
in the following table.
In 2005, we also used derivatives, such as swaps,
swaptions, Treasury futures and options, Eurodollar futures
and options, and forward contracts, to economically hedge
the risk of changes in the fair value of MSRs and other
retained interests, with the resulting gain or loss reflected
in income. Net derivative gains of $189 million for 2005
from economic hedges related to our mortgage servicing
activities are included on the income statement in “Mortgage
Banking – Servicing income, net.” The aggregate fair value
of these economic hedges was a net asset of $32 million
at December 31, 2005, and is included on the balance
sheet in “Other assets.”