Wells Fargo 2009 Annual Report Download - page 69


quarter could be higher than the average earnings at risk over
the 12-month simulation period, depending on the path of
interest rates and on our hedging strategies for MSRs. See the
“Risk Management – Mortgage Banking Interest Rate and
Market Risk” section in this Report for more information.
We use exchange-traded and over-the-counter (OTC)
interest rate derivatives to hedge our interest rate exposures.
The notional or contractual amount, credit risk amount and
estimated net fair value of these derivatives as of December
31, 2009 and 2008, are presented in Note 15 (Derivatives) to
Financial Statements in this Report. We use derivatives for
asset/liability management in three main ways:
• to convert a major portion of our long-term fixed-rate debt,
which we issue to finance the Company, from fixed-rate
payments to floating-rate payments by entering into
receive-fixed swaps;
• to convert the cash flows from selected asset and/or
liability instruments/portfolios from fixed-rate payments
to floating-rate payments or vice versa; and
• to hedge our mortgage origination pipeline, funded
mortgage loans and MSRs using interest rate swaps,
swaptions, futures, forwards and options.
MORTGAGE BANKING INTEREST RATE AND MARKET RISK We
originate, fund and service mortgage loans, which subjects
us to various risks, including credit, liquidity and interest
rate risks. Based on market conditions and other factors, we
reduce credit and liquidity risks by selling or securitizing
some or all of the long-term fixed-rate mortgage loans we
originate and most of the ARMs we originate. On the other
hand, we may hold originated ARMs and fixed-rate mortgage
loans in our loan portfolio as an investment for our growing
base of core deposits. We determine whether the loans will be
held for investment or held for sale at the time of commitment.
We may subsequently change our intent to hold loans for
investment and sell some or all of our ARMs or fixed-rate
mortgages as part of our corporate asset/liability management.
We may also acquire and add to our securities available for sale
a portion of the securities issued at the time we securitize mort-
gages held for sale (MHFS).
Notwithstanding the continued downturn in the housing
sector, and the continued lack of liquidity in the nonconforming
secondary markets, our mortgage banking revenue growth
continued to be positive, reflecting the complementary origi-
nation and servicing strengths of the business. The secondary
market for agency-conforming mortgages functioned well
during the year.
Interest rate and market risk can be substantial in the
mortgage business. Changes in interest rates may potentially
reduce total origination and servicing fees, the value of our
residential MSRs measured at fair value, the value of MHFS
and the associated income and loss reflected in mortgage
banking noninterest income, the income and expense
associated with instruments (economic hedges) used to
hedge changes in the fair value of MSRs and MHFS, and the
value of derivative loan commitments (interest rate “locks”)
extended to mortgage applicants.
Interest rates affect the amount and timing of origination
and servicing fees because consumer demand for new mort-
gages and the level of refinancing activity are sensitive to
changes in mortgage interest rates. Typically, a decline in
mortgage interest rates will lead to an increase in mortgage
originations and fees and may also lead to an increase in ser-
vicing fee income, depending on the level of new loans added
to the servicing portfolio and prepayments. Given the time
it 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 affect 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.
We elected to measure MHFS at fair value prospectively
for new prime MHFS originations for which an active sec-
ondary market and readily available market prices existed
to reliably support fair value pricing models used for these
loans. At December 31, 2008, we measured at fair value simi-
lar MHFS acquired from Wachovia. Loan origination fees on
these loans are recorded when earned, and related direct loan
origination costs and fees are recognized when incurred. We
also elected to measure at fair value certain of our other inter-
ests held related to residential loan sales and securitizations.
We believe that the election for new prime MHFS and other
interests held, which are now hedged with free-standing
derivatives (economic hedges) along with our MSRs, reduces
certain timing differences and better matches changes in the
value of these assets with changes in the value of derivatives
used as economic hedges for these assets. During 2008 and
2009, in response to continued secondary market illiquidity,
we continued to originate certain prime non-agency loans to
be held for investment for the foreseeable future rather than
to be held for sale.
We initially measure and carry our residential MSRs at
fair value, 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 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 and periodically benchmark our
estimates to independent appraisals. 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 significant
assumptions included in the periodic valuation of MSRs,
including prepayment speeds, expected returns and potential
risks on the servicing asset portfolio, the value of escrow
balances and other servicing valuation elements.
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,