Wells Fargo 2010 Annual Report Download - page 177

Cash Flow Hedges
We hedge floating-rate debt against future interest rate increases
by using interest rate swaps, caps, floors and futures to limit
variability of cash flows due to changes in the benchmark
interest rate. We also use interest rate swaps and floors to hedge
the variability in interest payments received on certain floating-
rate commercial loans, due to changes in the benchmark interest
rate. Gains and losses on derivatives that are reclassified from
cumulative OCI to current period earnings are included in the
line item in which the hedged item’s effect on earnings is
recorded. All parts of gain or loss on these derivatives are
included in the assessment of hedge effectiveness. We assess
hedge effectiveness using regression analysis, both at inception
of the hedging relationship and on an ongoing basis. The
regression analysis involves regressing the periodic changes in
cash flows of the hedging instrument against the periodic
changes in cash flows of the forecasted transaction being hedged
due to changes in the hedged risk(s). The assessment includes an
evaluation of the quantitative measures of the regression results
used to validate the conclusion of high effectiveness.
Based upon current interest rates, we estimate that
$367 million of deferred net gains on derivatives in OCI at
December 31, 2010, will be reclassified as earnings during the
next twelve months, compared with $284 million at
December 31, 2009. Future changes to interest rates may
significantly change actual amounts reclassified to earnings. We
are hedging our exposure to the variability of future cash flows
for all forecasted transactions for a maximum of 8 years for both
hedges of floating-rate debt and floating-rate commercial loans.
The following table shows the net gains (losses) recognized
related to derivatives in cash flow hedging relationships.
Year ended
December 31,
(in millions) 2010 2009
Gains (after tax) recognized in OCI on derivatives $ 468 107
Gains (pre tax) reclassified from cumulative OCI into net interest income 613 531
Gains (pre tax) recognized in noninterest income on derivatives (1) 6 42
(1) Represents ineffectiveness recognized on cash flow hedge derivatives.
Free-Standing Derivatives
We use free-standing derivatives (economic hedges), in addition
to debt securities available for sale, to hedge the risk of changes
in the fair value of residential MSRs measured at fair value,
certain residential MHFS, derivative loan commitments and
other interests held. The resulting gain or loss on these economic
hedges is reflected in other income.
The derivatives used to hedge these MSRs measured at fair
value, which include swaps, swaptions, forwards, Eurodollar and
Treasury futures and options contracts, resulted in net derivative
gains of $4.5 billion in 2010 and $6.8 billion in 2009, which are
included in mortgage banking noninterest income. The
aggregate fair value of these derivatives was a net liability of
$943 million and $961 million at December 31, 2010 and 2009,
respectively. Changes in fair value of debt securities available for
sale (unrealized gains and losses) are not included in servicing
income, but are reported in cumulative OCI (net of tax) or, upon
sale, are reported in net gains (losses) on debt securities
available for sale.
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 substantially all residential MHFS, 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 the fair value
measurement of 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. Fair value 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 affected primarily by changes in interest rates and the passage
of time. However, changes in investor demand can also cause
changes in the value of the underlying loan value that cannot be
hedged. The aggregate fair value of derivative loan commitments
in the balance sheet was a net liability of $271 million and
$312 million at December 31, 2010 and 2009, respectively, and
is included in the caption “Interest rate contracts” under
“Customer accommodation, trading and other free-standing
derivatives” in the first table in this Note.
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 liabilities 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 derivatives 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.
Free-standing derivatives also 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 currency 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
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