Wells Fargo 2009 Annual Report Download - page 151

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Year ended
(in millions) December 31, 2009
Gains (losses) recognized on free-standing
derivatives (economic hedges)
Interest rate contracts (1)
Recognized in noninterest income:
Mortgage banking $5,582
Other (15)
Foreign exchange contracts 133
Credit contracts (269)
Subtotal 5,431
Gains (losses) recognized on customer
accommodation, trading and other
free-standing derivatives
Interest rate contracts (2)
Recognized in noninterest income:
Mortgage banking 2,035
Other 1,139
Commodity contracts 29
Equity contracts (275)
Foreign exchange contracts 607
Credit contracts (621)
Other (187)
Subtotal 2,727
Net gains recognized related to derivatives
not designated as hedging instruments $8,158
(1) Predominantly mortgage banking noninterest income including gains (losses)
on the derivatives used as economic hedges of MSRs, interest rate lock
commitments, loans held for sale and mortgages held for sale.
(2) Predominantly mortgage banking noninterest income including gains (losses)
on interest rate lock commitments.
Interest rate lock commitments for residential mortgage
loans that we intend to sell are considered free-standing
derivatives. Our interest rate exposure on these derivative
loan commitments, as well as most new prime residential
MHFS for which we have elected the fair value option, is
hedged with free-standing derivatives (economic hedges)
such as forwards and options, Eurodollar futures and options,
and Treasury futures, forwards and options contracts. The
commitments, free-standing derivatives and residential MHFS
are carried at fair value with changes in fair value included in
mortgage banking noninterest income. For interest rate lock
commitments we include, at inception and during the life of
the loan commitment, the expected net future cash flows
related to the associated servicing of the loan as part of the
fair value measurement of derivative loan commitments.
Changes subsequent to inception are based on changes in
fair value of the underlying loan resulting from the exercise of
the commitment and 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 affect-
ed primarily by changes in interest rates and the passage of
time. However, changes in investor demand, such as concerns
about credit risk, can also cause changes in the spread rela-
tionships between underlying loan value and the derivative
financial instruments that cannot be hedged. The aggregate
fair value of derivative loan commitments in the balance
sheet was a net liability of $312 million and a net asset of
$125 million at December 31, 2009, and 2008, respectively,
and is included in the caption “Interest rate contracts” under
“Customer accommodation, trading and other free standing
derivatives” in the table on page 147.
We also enter into various derivatives primarily to provide
derivative products to customers. To a lesser extent, we take
positions based on market expectations or to benefit from
price differentials between financial instruments and markets.
These derivatives are not linked to specific assets and liabili-
ties in the balance sheet or to forecasted transactions in an
accounting hedge relationship and, therefore, do not qualify
for hedge accounting. We also enter into free-standing deriva-
tives for risk management that do not otherwise qualify for
hedge accounting. They are carried at fair value with changes
in fair value recorded as part of other noninterest income.
Additionally, free-standing derivatives include embedded
derivatives that are required to be accounted for separate
from their host contract. We periodically issue hybrid long-
term notes and CDs where the performance of the hybrid
instrument notes is linked to an equity, commodity or cur-
rency index, or basket of such indices. These notes contain
explicit terms that affect some or all of the cash flows or the
value of the note in a manner similar to a derivative instru-
ment and therefore are considered to contain an “embedded”
derivative instrument. The indices on which the performance
of the hybrid instrument is calculated are not clearly and
closely related to the host debt instrument. In accordance
with accounting guidance for derivatives, the “embedded”
derivative is separated from the host contract and accounted
for as a free-standing derivative.
The following table shows the net gains (losses)
recognized in the income statement related to derivatives
not designated as hedging instruments under the Derivatives
and Hedging topic of the Codification.
Credit Derivatives
We use credit derivatives to manage exposure to credit
risk related to lending and investing activity and to assist
customers with their risk management objectives. This may
include protection sold to offset purchased protection in
structured product transactions, as well as liquidity agree-
ments written to special purpose vehicles. The maximum
exposure of sold credit derivatives is managed through
posted collateral, purchased credit derivatives and similar
products in order to achieve our desired credit risk profile.
This credit risk management provides an ability to recover a
significant portion of any amounts that would be paid under
the sold credit derivatives. We would be required to perform
under the noted credit derivatives in the event of default by
the referenced obligors. Events of default include events
such as bankruptcy, capital restructuring or lack of principal
and/or interest payment. In certain cases, other triggers may
exist, such as the credit downgrade of the referenced obligors
or the inability of the special purpose vehicle for which we
have provided liquidity to obtain funding.
The following table provides details of sold and purchased
credit derivatives. In 2009, we exited the legacy Wachovia
market making activity of credit correlation trading resulting
in a significant reduction in our credit derivative and
counterparty credit exposures from December 31, 2008.