Wells Fargo 2010 Annual Report Download - page 88

Critical Accounting Policies (continued)
The amount of cash flows expected to be collected and,
accordingly, the adequacy of the allowance for loan loss due to
certain decreases in cash flows expected to be collected, is
particularly sensitive to changes in loan credit quality. The
sensitivity of the overall allowance for credit losses, including
PCI loans, is presented in the preceding section, “Critical
Accounting Policies – Allowance for Credit Losses.”
PCI loans that were classified as nonperforming loans by
Wachovia are no longer classified as nonperforming because, at
acquisition, we believe we will fully collect the new carrying value
of these loans and due to the existence of the accretable yield. It
is important to note that judgment is required to classify PCI
loans as performing and is dependent on having a reasonable
expectation about the timing and amount of cash flows expected
to be collected, even if the loan is contractually past due.
See the “Risk Management – Credit Risk Management”
section and Note 6 (Loans and Allowance for Credit Losses) to
Financial Statements in this Report for further discussion of PCI
loans.
Valuation of Residential Mortgage Servicing Rights
Mortgage servicing rights (MSRs) are assets that represent the
rights to service mortgage loans for others. We recognize MSRs
when we purchase servicing rights from third parties, or retain
servicing rights in connection with the sale or securitization of
loans we originate (asset transfers). We also have MSRs acquired
in the past under co-issuer agreements that provide for us to
service loans that were originated and securitized by third-party
correspondents. We initially measure and carry substantially all
of our MSRs related to residential mortgage loans at fair value.
At the end of each quarter, we determine the fair value of
MSRs using a valuation model that calculates the present value
of estimated future net servicing income. The model incorporates
assumptions that market participants use in estimating future
net servicing income, including estimates of prepayment speeds
(including housing price volatility), discount rate, default rates,
cost to service (including delinquency and foreclosure costs),
escrow account earnings, contractual servicing fee income,
ancillary income and late fees.
To reduce the sensitivity of earnings to interest rate and
market value fluctuations, we may use securities available for
sale and free-standing derivatives (economic hedges) to hedge
the risk of changes in the fair value of MSRs, with the resulting
gains or losses reflected in income. Changes in the fair value of
the MSRs from changing mortgage interest rates are generally
offset by gains or losses in the fair value of the derivatives and
the particular instruments used to hedge the MSRs. In addition,
we also consider origination volume in our risk management
strategy as it tends to act as a “natural hedge.” For example, as
interest rates decline, servicing values generally decrease and
fees from origination volume tend to increase. Conversely, as
interest rates increase, the fair value of the MSRs generally
increases, while fees from origination volume tend to decline. See
the “Risk Management – Mortgage Banking Interest Rate and
Market Risk” section in this Report for discussion of the timing
of the effect of changes in mortgage interest rates.
Net servicing income, a component of mortgage banking
noninterest income, includes the changes from period to period
in fair value of both our residential MSRs and the free-standing
derivatives (economic hedges) used to hedge our residential
MSRs. Changes in the fair value of residential MSRs from period
to period result from (1) changes in the valuation model inputs or
assumptions (principally reflecting changes in discount rates and
prepayment speed assumptions, mostly due to changes in
interest rates and costs to service, including delinquency and
foreclosure costs), and (2) other changes, representing changes
due to collection/realization of expected cash flows.
We use a dynamic and sophisticated model to estimate the
value of our MSRs. The model is validated by an independent
internal model validation group operating in accordance with
Company policies. Senior management reviews all significant
assumptions quarterly. Mortgage loan prepayment speed – a key
assumption in the model – is the annual rate at which borrowers
are forecasted to repay their mortgage loan principal. The
discount rate used to determine the present value of estimated
future net servicing income – another key assumption in the
model – is the required rate of return investors in the market
would expect for an asset with similar risk. To determine the
discount rate, we consider the risk premium for uncertainties
from servicing operations (e.g., possible changes in future
servicing costs, ancillary income and earnings on escrow
accounts). Both assumptions can, and generally will, change
quarterly as market conditions and interest rates change. For
example, an increase in either the prepayment speed or discount
rate assumption results in a decrease in the fair value of the
MSRs, while a decrease in either assumption would result in an
increase in the fair value of the MSRs. In recent years, there have
been significant market-driven fluctuations in loan prepayment
speeds and the discount rate. These fluctuations can be rapid and
may be significant in the future. Therefore, estimating
prepayment speeds within a range that market participants
would use in determining the fair value of MSRs requires
significant management judgment.
The valuation and sensitivity of MSRs is discussed further in
Note 1 (Summary of Significant Accounting Policies), Note 8
(Securitizations and Variable Interest Entities), Note 9
(Mortgage Banking Activities) and Note 16 (Fair Values of Assets
and Liabilities) to Financial Statements in this Report.
Liability for Mortgage Loan Repurchase Losses
We sell residential mortgage loans to various parties, including
(1) Freddie Mac and Fannie Mae (GSEs), which include the
mortgage loans in GSE-guaranteed mortgage securitizations, (2)
special purpose entities that issue private label MBS, and (3)
other financial institutions that purchase mortgage loans for
investment or private label securitization. In addition, we pool
FHA-insured and VA-guaranteed mortgage loans, which back
securities guaranteed by GNMA. The agreements under which
we sell mortgage loans and the insurance or guaranty
agreements with FHA and VA contain provisions that include
various representations and warranties regarding the origination
and characteristics of the mortgage loans. Although the specific
representations and warranties vary among different sales,
insurance or guarantee agreements, they typically cover
ownership of the loan, compliance with loan criteria set forth in
the applicable agreement, validity of the lien securing the loan,
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