Wells Fargo 2007 Annual Report Download - page 105

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these fair value hedges is recorded as part of noninterest
income. We made this change after converting these hedge
relationships to the long-haul method of assessing hedge
effectiveness, which results in recognition of more ineffec-
tiveness compared to the short-cut method. Consistent with
our asset/liability management strategy of converting fixed-
rate debt to floating-rates, we believe interest expense should
reflect only the current contractual interest cash flows on
the liabilities and the related swaps. In addition, we use
derivatives, such as Treasury and LIBOR futures and swaps,
to hedge changes in fair value due to changes in interest rates
of our commercial real estate mortgage loans held for sale.
Prior to March 31, 2007, we used derivatives, such as
Treasury and LIBOR futures and swaps, to hedge changes in
fair value due to changes in interest rates of our franchise
loans held for sale. Based upon a change in our intent, these
loans have since been reclassified to held for investment, and
therefore we no longer hedge these loans. The ineffective
portion of these fair value hedges is recorded as part of
mortgage banking noninterest income in the income statement.
Finally, we use interest rate swaps to hedge against changes
in fair value of certain debt securities that are classified
as securities available for sale, primarily municipal bond
securities beginning in second quarter 2006 and commercial
mortgage-backed securities beginning in fourth quarter 2007,
due to changes in interest rates. The ineffective portion of
these fair value hedges is recorded in “Net gains (losses) on
debt securities available for sale” in the income statement.
For fair value hedges of long-term debt and certificates of
deposit, commercial real estate loans, franchise loans and
debt securities, all parts of each derivative’s gain or loss
due to the hedged risk are included in the assessment of
hedge effectiveness.
For the previously mentioned fair value hedging relation-
ships, we use regression analysis to assess hedge effectiveness,
both at inception of the hedging relationship and on an
ongoing basis. The regression analysis involves regressing
the periodic change in fair value of the hedging instrument
against the periodic changes in fair value of the asset or
liability being hedged due to changes in the hedged risk(s).
The assessment includes an evaluation of the quantitative
measures of the regression results used to validate the
conclusion of high effectiveness.
Prior to June 1, 2006, we used the short-cut method of
assessing hedge effectiveness for certain fair value hedging
relationships of U.S. dollar denominated fixed-rate long-term
debt and certificates of deposits. The short-cut method
allows an entity to assume perfect hedge effectiveness if
certain qualitative criteria are met, and accordingly, does not
require quantitative measures such as regression analysis. We
used the short-cut method only when appropriate, based on
the qualitative assessment of the criteria in paragraph 68 of
FAS 133, performed at inception of the hedging relationship
and on an ongoing basis. Effective January 1, 2006, for any
new hedging relationships of these types, we used the long-
haul method to assess hedge effectiveness. By June 1, 2006,
we stopped using the short-cut method by de-designating all
remaining short-cut relationships and re-designating them to
use the long-haul method to evaluate hedge effectiveness.
We enter into equity collars to lock in share prices
between specified levels for certain equity securities. As
permitted, we include the intrinsic value only (excluding
time value) when assessing hedge effectiveness. We assess
hedge effectiveness based on a dollar-offset ratio, at inception
of the hedging relationship and on an ongoing basis, by
comparing cumulative changes in the intrinsic value of the
equity collar with changes in the fair value of the hedged
equity securities. The net derivative gain or loss related to
the equity collars is recorded in other noninterest income
in the income statement.
At December 31, 2007, all designated fair value hedges
continued to qualify as fair value hedges.
Cash Flow Hedges
We use derivatives, such as forwards, options and Eurodollar
and Treasury futures, to hedge forecasted sales of mortgage
loans. 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
interest rate swaps and floors to hedge the variability in
interest payments received on certain floating-rate commer-
cial loans, due to changes in interest rates. Upon adoption of
FAS 159 on January 1, 2007, derivatives used to hedge the
forecasted sales of prime residential MHFS originated subse-
quent to January 1, 2007, were accounted for as economic
hedges. We previously accounted for these derivatives as cash
flow hedges under FAS 133. 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 record-
ed. All parts of gain or loss on these derivatives are included
in the assessment of hedge effectiveness. For all cash flow
hedges, we assess hedge effectiveness using regression analy-
sis, both at inception of the hedging relationship and on an
ongoing basis. The regression analysis involves regressing the
periodic changes in cash flows of the hedging instrument
against the periodic changes in cash flows of the forecasted
transaction being hedged due to changes in the hedged
risk(s). The assessment includes an evaluation of the quanti-
tative measures of the regression results used to validate the
conclusion of high effectiveness. As of December 31, 2007,
all designated cash flow hedges continued to qualify as cash
flow hedges.
We expect that $63 million of deferred net gains on
derivatives in other comprehensive income at December 31,
2007, will be reclassified as earnings during the next twelve
months, compared with $53 million of net deferred gains
and $13 million of net deferred losses at December 31, 2006
and 2005, respectively. We are hedging our exposure to the
variability of future cash flows for all forecasted transactions
for a maximum of seven years for both hedges of floating-rate
senior debt and floating-rate commercial loans.