Wells Fargo 2011 Annual Report Download - page 106

Risk Factors (continued)
could result in materially higher credit losses, including for our
home equity portfolio.
The Wachovia merger also increased our CRE exposure,
particularly in California and Florida, and we are currently the
largest CRE lender in the U.S. A deterioration in economic
conditions that negatively affects the business performance of
our CRE borrowers, including increases in interest rates and/or
declines in commercial property values, could result in materially
higher credit losses and have a material adverse effect on our
financial results and condition.
The European debt crisis, which has resulted in deteriorating
economic conditions in Europe and ratings agency downgrades
of the sovereign debt ratings of several European countries, has
increased foreign credit risk. Although our foreign loan exposure
represented only approximately 5% of our total consolidated
outstanding loans and 3% of our total assets at
December 31, 2011, continued European economic difficulties
could indirectly have a material adverse effect on our credit
performance and results of operations and financial condition to
the extent it negatively affects the U.S. economy and/or our
borrowers who have foreign operations.
For more information, refer to the “Risk Management –
Credit Risk Management” section and Note 6 (Loans and
Allowance for Credit Losses) to Financial Statements in this
Report.
We may incur losses on loans, securities and other
acquired assets of Wachovia that are materially greater
than reflected in our fair value adjustments. We
accounted for the Wachovia merger under the purchase method
of accounting, recording the acquired assets and liabilities of
Wachovia at fair value. All PCI loans acquired in the merger were
recorded at fair value based on the present value of their
expected cash flows. We estimated cash flows using internal
credit, interest rate and prepayment risk models using
assumptions about matters that are inherently uncertain. We
may not realize the estimated cash flows or fair value of these
loans. In addition, although the difference between the pre-
merger carrying value of the credit-impaired loans and their
expected cash flows – the “nonaccretable difference” – is
available to absorb future charge-offs, we may be required to
increase our allowance for credit losses and related provision
expense because of subsequent additional credit deterioration in
these loans.
For more information, refer to the “Critical Accounting
Policies – Purchased Credit-Impaired (PCI) Loans” and “Risk
Management – Credit Risk Management” sections in this Report.
Our mortgage banking revenue can be volatile from
quarter to quarter, including as a result of changes in
interest rates and the value of our MSRs and MHFS,
and we rely on the GSEs to purchase our conforming
loans to reduce our credit risk and provide liquidity to
fund new mortgage loans. We were the largest mortgage
originator and residential mortgage servicer in the U.S. as of
December 31, 2011, and we earn revenue from fees we receive for
originating mortgage loans and for servicing mortgage loans. As
a result of our mortgage servicing business, we have a sizeable
portfolio of MSRs. An 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 substantially all 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 also
measure at fair value prime MHFS for which an active secondary
market and readily available market prices exist. In addition, we
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.
When rates rise, the demand for mortgage loans usually tends
to fall, reducing the revenue we receive from loan originations.
Under the same conditions, revenue from our MSRs can increase
through increases in fair value. When rates fall, mortgage
originations usually tend to increase and the value of our MSRs
usually tends to decline, also with some offsetting revenue effect.
Even though they can act as a “natural hedge,” the hedge is not
perfect, either in amount or timing. For example, the negative
effect on revenue from a decrease in the fair value of residential
MSRs is generally immediate, but any offsetting revenue benefit
from more originations and the MSRs relating to the new loans
would generally accrue over time. It is also possible that, because
of economic conditions and/or a weak or deteriorating housing
market similar to current market conditions, even if interest
rates were to fall or remain low, mortgage originations may also
fall or any increase in mortgage originations may not be enough
to offset the decrease in the MSRs value caused by the lower
rates.
We typically use derivatives and other instruments to hedge
our mortgage banking interest rate risk. We generally do not
hedge all of our risk, and we may not be successful in hedging
any of the risk. Hedging is a complex process, requiring
sophisticated models and constant monitoring, and is not a
perfect science. We may use hedging instruments tied to U.S.
Treasury rates, LIBOR or Eurodollars that may not perfectly
correlate with the value or income being hedged. We could incur
significant losses from our hedging activities. There may be
periods where we elect not to use derivatives and other
instruments to hedge mortgage banking interest rate risk.
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 GSEs to purchase loans that meet their conforming
loan requirements and on other capital markets investors to
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