Wells Fargo 2011 Annual Report Download - page 81

mortgages 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
servicing 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 measure MHFS at fair value for prime MHFS
originations for which an active secondary market and readily
available market prices exist to reliably support fair value
pricing models used for these loans. Loan origination fees on
these loans are recorded when earned, and related direct loan
origination costs are recognized when incurred. We also
measure at fair value certain of our other interests held related
to residential loan sales and securitizations. We believe fair
value measurement for prime MHFS and other interests held,
which we hedge with free-standing derivatives (economic
hedges) along with our MSRs measured at fair value, 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 2011 and
2010, 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. In addition, in 2011 and 2010, we originated
certain prime agency-eligible loans to be held for investment as
part of our asset/liability management strategy.
We initially measure all of our MSRs at fair value and carry
substantially all of them at fair value depending on our strategy
for managing interest rate risk. 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 carried at
fair value 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. See “Critical
Accounting Policies – Valuation of Residential Mortgage
Servicing Rights” section of this Report for additional
information. 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
for MSRs carried at fair value, net of any gains on free-standing
derivatives (economic hedges) used to hedge MSRs. We may
choose not to fully hedge all 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.” An increase in
interest rates generally reduces the propensity for refinancing,
extends the expected duration of the servicing portfolio and
therefore increases the estimated fair value of the MSRs.
However, an increase in interest rates can also reduce
mortgage loan demand and therefore reduce origination
income.
The price risk associated with our MSRs is economically
hedged with a combination of highly liquid interest rate
forward instruments including mortgage forward contracts,
interest rate swaps and interest rate options. All of the
instruments included in the hedge are marked to market daily.
Because the hedging instruments are traded in highly liquid
markets, their prices are readily observable and are fully
reflected in each quarter’s mark to market. Quarterly MSR
hedging results include a combination of directional gain or
loss due to market changes as well as any carry income
generated. If the economic hedge is effective, its overall
directional hedge gain or loss will offset the change in the
valuation of the underlying MSR asset. Gains or losses
associated with these economic hedges are included in
mortgage banking noninterest income. Consistent with our
longstanding approach to hedging interest rate risk in the
mortgage business, the size of the hedge and the particular
combination of hedging instruments at any point in time is
designed to reduce the volatility of the mortgage business’s
earnings over various time frames within a range of mortgage
interest rates. Because market factors, the composition of the
mortgage servicing portfolio and the relationship between the
origination and servicing sides of our mortgage business
change continually, the types of instruments used in our
hedging are reviewed daily and rebalanced based on our
evaluation of current market factors and the interest rate risk
inherent in our MSRs portfolio. Throughout 2011, our
economic hedging strategy generally used forward mortgage
purchase contracts that were effective at offsetting the impact
of interest rates on the value of the MSR asset.
Mortgage forward contracts are designed to pass the full
economics of the underlying reference mortgage securities to
the holder of the contract, including both the directional gain
or loss from the forward delivery of the reference securities and
the corresponding carry income. Carry income represents the
contract’s price accretion from the forward delivery price to the
current spot price including both the yield earned on the
reference securities and the market implied cost of financing
during the period. The actual amount of carry income earned
on the hedge each quarter will depend on the amount of the
underlying asset that is hedged and the particular instruments
included in the hedge. The level of carry income is driven by
the slope of the yield curve and other market driven supply and
demand factors affecting the specific reference securities. A
steep yield curve generally produces higher carry income while
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