Wells Fargo 2006 Annual Report Download - page 58

56
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 impact origination
and servicing fees with a lag. The amount and timing of the
impact on origination and servicing fees will depend on the
magnitude, speed and duration of the change in interest rates.
Under FAS 156, which we adopted January 1, 2006, we
have elected to use the fair value measurement method to
initially measure and carry our residential MSRs, which rep-
resent substantially all of our MSRs. Under this method, the
initial measurement of fair value of MSRs at the time we sell
or securitize mortgage loans is recorded as a component of
net gains on mortgage loan origination/sales activities. The
carrying value of MSRs reflects changes in fair value at the
end of each quarter and changes are included in net servicing
income, a component of mortgage banking noninterest
income. If the fair value of the MSRs increases, income is
recognized; if the fair value of the MSRs decreases, a loss is
recognized. We use a dynamic and sophisticated model to
estimate the fair value of our MSRs. While the valuation
of MSRs can be highly subjective and involve complex
judgments by management about matters that are inherently
unpredictable, changes in interest rates influence a variety
of assumptions included in the periodic valuation of MSRs.
Assumptions affected include prepayment speed, expected
returns and potential risks on the servicing asset portfolio,
the value of escrow balances and other servicing valuation
elements impacted by interest rates.
A decline in interest rates increases the propensity for
refinancing, reduces the expected duration of the servicing
portfolio and therefore reduces the estimated fair value of
MSRs. This reduction in fair value causes a charge to income
(net of any gains on free-standing derivatives (economic
hedges) used to hedge MSRs). We may choose to not fully
hedge all of the potential decline in the value of our MSRs
resulting from a decline in interest rates because the potential
increase in origination/servicing fees in that scenario provides
a partial “natural business hedge.” In a rising rate period,
when the MSRs may not be fully hedged with free-standing
derivatives, the change in the fair value of the MSRs that
can be recaptured into income will typically—although not
always—exceed the losses on any free-standing derivatives
hedging the MSRs. In 2006, the decrease in the fair value of
our MSRs and losses on free-standing derivatives used to
hedge the MSRs totaled $154 million.
Hedging the various sources of interest rate risk in mort-
gage banking is a complex process that requires sophisticated
modeling and constant monitoring. While we attempt to
balance these various aspects of the mortgage business, there
are several potential risks to earnings:
• MSRs valuation changes associated with interest rate
changes are recorded in earnings immediately within
the accounting period in which those interest rate
changes occur, whereas the impact of those same
changes in interest rates on origination and servicing
fees occur with a lag and over time. Thus, the mortgage
business could be protected from adverse changes in
interest rates over a period of time on a cumulative
basis but still display large variations in income from
one accounting period to the next.
• The degree to which the “natural business hedge” off-
sets changes in MSRs valuations is imperfect, varies at
different points in the interest rate cycle, and depends
not just on the direction of interest rates but on the
pattern of quarterly interest rate changes.
• Origination volumes, the valuation of MSRs and hedging
results and associated costs are also impacted by many
factors. Such factors include the mix of new business
between ARMs and fixed-rated mortgages, the relation-
ship between short-term and long-term interest rates,
the degree of volatility in interest rates, the relationship
between mortgage interest rates and other interest rate
markets, and other interest rate factors. Many of these
factors are hard to predict and we may not be able to
directly or perfectly hedge their effect.
• While our hedging activities are designed to balance
our mortgage banking interest rate risks, the financial
instruments we use may not perfectly correlate with the
values and income being hedged. For example, the change
in the value of ARMs production held for sale from
changes in mortgage interest rates may or may not be
fully offset by Treasury and LIBOR index-based financial
instruments used as economic hedges for such ARMs.
The total carrying value of our residential and commer-
cial MSRs was $18.0 billion at December 31, 2006, and
$12.5 billion, net of a valuation allowance of $1.2 billion, at
December 31, 2005. The weighted-average note rate on the
owned servicing portfolio was 5.92% at December 31, 2006,
and 5.72% at December 31, 2005. Our total MSRs were
1.41% of mortgage loans serviced for others at December
31, 2006, compared with 1.44% at December 31, 2005.
As part of our mortgage banking activities, we enter into
commitments to fund residential mortgage loans at specified
times in the future. A mortgage loan commitment is an interest
rate lock that binds us to lend funds to a potential borrower
at a specified interest rate and within a specified period of
time, generally up to 60 days after inception of the rate lock.
These loan commitments are derivative loan commitments if
the loans that will result from the exercise of the commitments
will be held for sale. Under FAS 133, Accounting for Derivative
Instruments and Hedging Activities (as amended), these
derivative loan commitments are recognized at fair value in
the balance sheet with changes in their fair values recorded
as part of mortgage banking noninterest income. Consistent
with SEC Staff Accounting Bulletin No. 105, Application of
Accounting Principles to Loan Commitments, we record no
value for the loan commitment at inception. Subsequent to
inception, we recognize the fair value of the derivative loan
commitment based on estimated changes in the fair value of
the underlying loan that would result from the exercise of
that commitment and on changes in the probability that
the loan will not fund within the terms of the commitment
(referred to as a fall-out factor). The value of that loan is