Wells Fargo 2009 Annual Report Download - page 85

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Loss of customer deposits and market illiquidity could increase
our funding costs. We rely on bank deposits to be a low cost and
stable source of funding for the loans we make. We compete with
banks and other financial services companies for deposits. If our
competitors raise the rates they pay on deposits our funding costs
may increase, either because we raise our rates to avoid losing
deposits or because we lose deposits and must rely on more
expensive sources of funding. Higher funding costs reduce our
net interest margin and net interest income. As discussed above,
the integration of Wells Fargo and Wachovia may result in the
loss of customer deposits.
We sell most of the mortgage loans we originate in order to
reduce our credit risk and provide funding for additional loans.
We rely on Fannie Mae and Freddie Mac to purchase loans that
meet their conforming loan requirements and on other capital
markets investors to purchase loans that do not meet those
requirements—referred to as “nonconforming” loans. Since
2007, investor demand for nonconforming loans has fallen
sharply, increasing credit spreads and reducing the liquidity for
those loans. In response to the reduced liquidity in the capital
markets, we may retain more nonconforming loans. When we
retain a loan not only do we keep the credit risk of the loan but
we also do not receive any sale proceeds that could be used to
generate new loans. Continued lack of liquidity could limit our
ability to fund—and thus originate—new mortgage loans, reducing
the fees we earn from originating and servicing loans. In addition,
we cannot assure that Fannie Mae and Freddie Mac will not
materially limit their purchases of conforming loans due to
capital constraints or change their criteria for conforming loans
(e.g., maximum loan amount or borrower eligibility).
Changes in interest rates could reduce our net interest income
and earnings. Our net interest income is the interest we earn on
loans, debt securities and other assets we hold less the interest
we pay on our deposits, long-term and short-term debt, and other
liabilities. Net interest income is a measure of both our net interest
margin— the difference between the yield we earn on our assets
and the interest rate we pay for deposits and our other sources
of funding—and the amount of earning assets we hold. Changes
in either our net interest margin or the amount of earning assets
we hold could affect our net interest income and our earnings.
Changes in interest rates can affect our net interest margin.
Although the yield we earn on our assets and our funding costs
tend to move in the same direction in response to changes in
interest rates, one can rise or fall faster than the other, causing
our net interest margin to expand or contract. Our liabilities
tend to be shorter in duration than our assets, so they may adjust
faster in response to changes in interest rates. When interest
rates rise, our funding costs may rise faster than the yield we
earn on our assets, causing our net interest margin to contract
until the yield catches up.
The amount and type of earning assets we hold can affect
our yield and net interest margin. We hold earning assets in the
form of loans and investment securities, among other assets.
If current economic conditions persist, we may continue to see
lower demand for loans by credit worthy customers, reducing our
yield. In addition, we may invest in lower yielding investment
securities for a variety of reasons, including in anticipation that
interest rates are likely to increase.
Changes in the slope of the “yield curve”—or the spread
between short-term and long-term interest rates— could also
reduce our net interest margin. Normally, the yield curve is
upward sloping, meaning short-term rates are lower than long-
term rates. Because our liabilities tend to be shorter in duration
than our assets, when the yield curve flattens or even inverts, our
net interest margin could decrease as our cost of funds increases
relative to the yield we can earn on our assets.
The interest we earn on our loans may be tied to U.S.-denomi-
nated interest rates such as the federal funds rate while the interest
we pay on our debt may be based on international rates such as
LIBOR. If the federal funds rate were to fall without a corresponding
decrease in LIBOR, we might earn less on our loans without any
offsetting decrease in our funding costs. This could lower our net
interest margin and our net interest income.
We assess our interest rate risk by estimating the effect on our
earnings under various scenarios that differ based on assumptions
about the direction, magnitude and speed of interest rate changes
and the slope of the yield curve. We hedge some of that interest
rate risk with interest rate derivatives. We also rely on the “natural
hedge” that our mortgage loan originations and servicing rights
can provide.
We do not hedge all of our interest rate risk. There is always the
risk that changes in interest rates could reduce our net interest
income and our earnings in material amounts, especially if actual
conditions turn out to be materially different than what we assumed.
For example, if interest rates rise or fall faster than we assumed
or the slope of the yield curve changes, we may incur significant
losses on debt securities we hold as investments. To reduce our
interest rate risk, we may rebalance our investment and loan
portfolios, refinance our debt and take other strategic actions.
We may incur losses when we take such actions.
For more information, refer to the “Risk Management – Asset/
Liability Management – Interest Rate Risk” section in this Report.
Changes in interest rates could also reduce the value of our
mortgage servicing rights and mortgages held for sale, reducing
our earnings. We have a sizeable portfolio of mortgage servicing
rights. A mortgage servicing right (MSR) is the right to service a
mortgage loan—collect principal, interest and escrow amounts—
for a fee. We acquire MSRs when we keep the servicing rights
after we sell or securitize the loans we have originated or when
we purchase the servicing rights to mortgage loans originated
by other lenders. We initially measure and carry our residential
MSRs using the fair value measurement method. Fair value is the
present value of estimated future net servicing income, calculated
based on a number of variables, including assumptions about the
likelihood of prepayment by borrowers.
Changes in interest rates can affect prepayment assumptions
and thus fair value. When interest rates fall, borrowers are usually
more likely to prepay their mortgage loans by refinancing them
at a lower rate. As the likelihood of prepayment increases, the fair
value of our MSRs can decrease. Each quarter we evaluate the fair
value of our MSRs, and any decrease in fair value reduces earnings
in the period in which the decrease occurs.
We measure at fair value new prime MHFS for which an active
secondary market and readily available market prices exist. We
also measure at fair value certain other interests we hold related
to residential loan sales and securitizations. Similar to other
interest-bearing securities, the value of these MHFS and other
interests may be negatively affected by changes in interest rates.
For example, if market interest rates increase relative to the yield
on these MHFS and other interests, their fair value may fall. We
may not hedge this risk, and even if we do hedge the risk with
derivatives and other instruments we may still incur significant
losses from changes in the value of these MHFS and other interests
or from changes in the value of the hedging instruments.