Wells Fargo 2007 Annual Report Download - page 65

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Under FAS 156, which we adopted January 1, 2006, we
elected to use the fair value measurement method to initially
measure and carry our residential MSRs, which represent
substantially all of our MSRs. Under this method, the MSRs
are recorded at fair value at the time we sell or securitize the
related mortgage loans. 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 mort-
gage 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
and periodically benchmark our estimates to independent
appraisals. While the valuation of MSRs can be highly sub-
jective and involve complex judgments by management
about matters that are inherently unpredictable, changes in
interest rates influence a variety of significant 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 generally 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 2007, the decrease in
the fair value of our MSRs net of the gains on free-standing
derivatives used to hedge the MSRs increased income by
$583 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 inter-
est rates on origination and servicing fees occur with a lag
and over time. Thus, the mortgage business could be pro-
tected from adverse changes in interest rates over a period
of time on a cumulative basis but still display large varia-
tions in income from one accounting period to the next.
• The degree to which the “natural business hedge” offsets
changes in MSRs valuations is imperfect, varies at differ-
ent 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 relationship
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 instru-
ments 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 commercial
MSRs was $17.2 billion at December 31, 2007, and $18.0 billion
at December 31, 2006. The weighted-average note rate on the
owned servicing portfolio was 6.01% at December 31, 2007,
and 5.92% at December 31, 2006. Our total MSRs were 1.20%
of mortgage loans serviced for others at December 31, 2007,
compared with 1.41% at December 31, 2006.
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. 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 nonin-
terest income. 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 the underlying loan is affected primarily by
changes in interest rates and the passage of time.
Outstanding derivative loan commitments expose us to
the risk that the price of the mortgage loans underlying the
commitments might decline due to increases in mortgage
interest rates from inception of the rate lock to the funding
of the loan. To minimize this risk, we utilize forwards and
options, Eurodollar futures, and Treasury futures, forwards
and options contracts as economic hedges against the poten-
tial decreases in the values of the loans. We expect that these
derivative financial instruments will experience changes in
fair value that will either fully or partially offset the changes
in fair value of the derivative loan commitments. However,
changes in investor demand, such as concerns about credit
risk, can also cause changes in the spread relationships
between underlying loan value and the derivative financial
instruments that cannot be hedged.