Wells Fargo 2013 Annual Report Download - page 89

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and we may not be able to directly or perfectly hedge their
effect.
While our hedging activities are designed to balance our
mortgage banking interest rate risks, the financial
instruments we use may not perfectly correlate with the
values and income being hedged. For example, the change
in the value of ARM production held for sale from changes
in mortgage interest rates may or may not be fully offset by
Treasury and LIBOR index-based financial instruments
used as economic hedges for such ARMs. Additionally,
hedge-carry income we earn on our economic hedges for the
MSRs may not continue if the spread between short-term
and long-term rates decreases, we shift composition of the
hedge to more interest rate swaps, or there are other
changes in the market for mortgage forwards that affect the
implied carry.
The total carrying value of our residential and commercial
MSRs was $16.8 billion and $12.7 billion at December 31, 2013
and 2012, respectively. The weighted-average note rate on our
portfolio of loans serviced for others was 4.52% and 4.77% at
December 31, 2013 and 2012, respectively. The carrying value of
our total MSRs represented 0.88% and 0.67% of mortgage loans
serviced for others at December 31, 2013 and 2012, respectively.
As part of our mortgage banking activities, we enter into
commitments to fund residential mortgage loans at specified
times in the future. A mortgage loan commitment is an interest
rate lock that binds us to lend funds to a potential borrower at a
specified interest rate and within a specified period of time,
generally up to 60 days after inception of the rate lock. These
loan commitments are derivative loan commitments if the loans
that will result from the exercise of the commitments will be held
for sale. These derivative loan commitments are recognized at
fair value on the balance sheet with changes in their fair values
recorded as part of mortgage banking noninterest income. The
fair value of these commitments 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 as part of the
fair value measurement of derivative loan commitments.
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 commitment is
affected primarily by changes in interest rates and the passage of
time.
Outstanding derivative loan commitments expose us to the
risk that the price of the mortgage loans underlying the
commitments might decline due to increases in mortgage
interest rates from inception of the rate lock to the funding of the
loan. To minimize this risk, we employ mortgage forwards and
options, Eurodollar futures and options, and Treasury futures,
forwards and options contracts as economic hedges against the
potential decreases in the values of the loans. We expect that
these derivative financial instruments will experience changes in
fair value that will either fully or partially offset the changes in
fair value of the derivative loan commitments. However, changes
in investor demand, such as concerns about credit risk, can also
cause changes in the spread relationships between underlying
loan value and the derivative financial instruments that cannot
be hedged.
MARKET RISK – TRADING ACTIVITIES We engage in trading
activities primarily to accommodate the investment and risk
management activities of our customers, execute economic
hedging to manage certain of our balance sheet risks and for a
very limited amount of proprietary trading for our own account.
These activities primarily occur within our trading businesses
and include entering into transactions with our customers that
are recorded as trading assets and liabilities on our balance
sheet. The primary risk metric used to monitor our trading
assets and liabilities is Value-at-Risk (VaR). Value-at-Risk is
covered in more detail in the Value-At-Risk Overview section in
this Report. Assets and liabilities held outside of our trading
portfolio are primarily monitored through the use of earnings
simulations as described above.
Valuation Process All of our trading assets and liabilities,
including securities, foreign exchange transactions, commodity
transactions and derivatives are carried at fair value. Income
earned related to these trading activities include net interest
income and changes in fair value related to trading assets and
liabilities. Net interest income earned on trading assets and
liabilities is reflected in the interest income and interest expense
components of our income statement. Changes in fair value of
trading assets and liabilities are reflected in net gains (losses) on
trading activities, a component of noninterest income in our
income statement. For a discussion of our significant accounting
policies and how we determine fair value, see Note 1 (Summary
of Significant Accounting Policies) to Financial Statements in
this Report. For descriptions of the valuation methodologies we
use for assets and liabilities recorded at fair value on a recurring
basis and for estimating fair value for financial instruments at
fair value, see Note 16 (Derivatives) and Note 17 (Fair Values of
Assets and Liabilities) to Financial Statements in this Report.
From a market risk perspective, our net income is exposed to
changes in the fair value of trading assets and liabilities due to
changes in interest rates, credit spreads, foreign exchange rates,
equity and commodity prices. Our Market Risk Committee,
which is a management committee reporting to the Finance
Committee of the Board, provides governance and oversight over
market risk-taking activities across the Company.
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