Wells Fargo 2006 Annual Report Download - page 117

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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 the
gain 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
accommodations 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, including
economic hedge derivatives. To a lesser extent, we take
positions based on market expectations or to benefit from
price differentials between financial instruments and markets.
Additionally, free-standing derivatives include embedded
derivatives that are required to be separately accounted
for from their host contracts.
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 and
other criteria 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
Prior to January 1, 2006, we used derivatives as fair value
hedges to manage the risk of changes in the fair value of
residential MSRs and other interests held. These derivatives
included interest rate swaps, swaptions, Treasury futures
and options, Eurodollar futures and options, and forward
contracts. 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) were excluded from the evaluation of hedge
effectiveness, but were reflected in earnings. Upon adoption
of FAS 156, derivatives used to hedge our residential MSRs
are no longer accounted for as fair value hedges under
FAS 133, but as economic hedges. Net derivative gains and
losses related to our residential mortgage servicing activities
are included in “Servicing income, net” in Note 21.
We use interest rate swaps to convert certain of our fixed-
rate long-term debt and certificates of deposit to floating
rates to hedge our exposure to interest rate risk. We also
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. The ineffective portion of
these fair value hedges is recorded as part of interest expense
in the income statement. In addition, 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. For fair value hedges of
long-term debt and certificates of deposit, foreign currency,
and commercial real estate and franchise loans, all parts
of each derivative’s gain or loss due to the hedged risk
are included in the assessment of hedge effectiveness.
Note 26: Derivatives
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,
2006, Wells Fargo Bank, N.A. met these requirements.