Wells Fargo 2005 Annual Report Download - page 54

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Asset/Liability and Market Risk Management
Asset/liability management involves the evaluation, monitoring
and management of interest rate risk, market risk, liquidity
and funding. The Corporate Asset/Liability Management
Committee (Corporate ALCO)—which oversees these
risks and reports periodically to the Finance Committee
of the Board of Directors—consists of senior financial
and business executives. Each of our principal business
groups—Community Banking (including Mortgage Banking),
Wholesale Banking and Wells Fargo Financial—have
individual asset/liability management committees and
processes linked to the Corporate ALCO process.
INTEREST RATE RISK
Interest rate risk, which potentially can have a significant
earnings impact, is an integral part of being a financial inter-
mediary. We are subject to interest rate risk because:
• assets and liabilities may mature or reprice at different
times (for example, if assets reprice faster than liabilities
and interest rates are generally falling, earnings will
initially decline);
• assets and liabilities may reprice at the same time but
by different amounts (for example, when the general
level of interest rates is falling, we may reduce rates
paid on checking and savings deposit accounts by an
amount that is less than the general decline in market
interest rates);
• short-term and long-term market interest rates may
change by different amounts (for example, the shape
of the yield curve may affect new loan yields and
funding costs differently); or
• the remaining maturity of various assets or liabilities
may shorten or lengthen as interest rates change (for
example, if long-term mortgage interest rates decline
sharply, mortgage-backed securities held in the securities
available for sale portfolio may prepay significantly earlier
than anticipated—which could reduce portfolio income).
Interest rates may also have a direct or indirect effect on
loan demand, credit losses, mortgage origination volume, the
value of MSRs, the value of the pension liability and other
sources of earnings.
We assess interest rate risk by comparing our most likely
earnings plan with various earnings simulations using many
interest rate scenarios that differ in the direction of interest
rate changes, the degree of change over time, the speed of
change and the projected shape of the yield curve. For exam-
ple, as of December 31, 2005, our most recent simulation
indicated estimated earnings at risk of less than 1% of our
most likely earnings plan over the next 12 months using a
scenario in which the federal funds rate dropped 200 basis
points to 2.25% and the 10-year Constant Maturity Treasury
bond yield dropped 125 basis points to 3.25% over the
same period. Simulation estimates depend on, and will
change with, the size and mix of our actual and projected
balance sheet at the time of each simulation. Due to timing
differences between the quarterly valuation of MSRs and
the eventual impact of interest rates on mortgage banking
volumes, earnings at risk in any particular quarter could
be higher than the average earnings at risk over the twelve
month simulation period, depending on the path of interest
rates and on our MSRs hedging strategies. See “Mortgage
Banking Interest Rate Risk” below.
We use exchange-traded and over-the-counter interest rate
derivatives to hedge our interest rate exposures. The notional
or contractual amount, credit risk amount and estimated net
fair values of these derivatives as of December 31, 2005 and
2004, are presented in Note 26 (Derivatives) to Financial
Statements. We use derivatives for asset/liability management
in three ways:
• to convert a major portion of our long-term fixed-rate
debt, which we issue to finance the Company, from
fixed-rate payments to floating-rate payments by
entering into receive-fixed swaps;
• to convert the cash flows from selected asset and/or
liability instruments/portfolios from fixed-rate payments
to floating-rate payments or vice versa; and
• to hedge our mortgage origination pipeline, funded
mortgage loans and MSRs using interest rate swaps,
swaptions, futures, forwards and options.
MORTGAGE BANKING INTEREST RATE RISK
We originate, fund and service mortgage loans, which subjects
us to various risks, including credit, liquidity and interest rate
risks. We avoid unwanted credit and liquidity risks by selling
or securitizing virtually all of the long-term fixed-rate mort-
gage loans we originate and most of the ARMs we originate.
From time to time, we hold originated ARMs in portfolio as
an investment for our growing base of core deposits, and we
may subsequently sell some or all of these ARMs as part of
our corporate asset/liability management.
While credit and liquidity risks are relatively low
for mortgage banking activities, interest rate risk can be
substantial. Changes in interest rates may potentially impact
origination and servicing fees, the value of our MSRs, the
income and expense associated with instruments used to hedge
changes in the value of MSRs, and the value of derivative
loan commitments extended to mortgage applicants.
Interest rates impact the amount and timing of origina-
tion and servicing fees because consumer demand for new
mortgages and the level of refinancing activity are sensitive
to changes in mortgage interest rates. Typically, a decline in
mortgage interest rates will lead to an increase in mortgage
originations and fees and, depending on our ability to retain
market share, may also lead to an increase in servicing fees.
Given the time it takes for consumer behavior to fully react
to interest rate changes, as well as the time required for
processing a new application, providing the commitment,
and securitizing and selling the loan, interest rate changes will