Wells Fargo 2010 Annual Report Download - page 79

strengths of the business. The secondary market for agency-
conforming mortgages functioned well during the year.
Interest rate and market risk can be substantial in the
mortgage business. Changes in interest rates may potentially
reduce total origination and servicing fees, the value of our
residential MSRs measured at fair value, the value of MHFS and
the associated income and loss reflected in mortgage banking
noninterest income, the income and expense associated with
instruments (economic hedges) used to hedge changes in the fair
value of MSRs and MHFS, and the value of derivative loan
commitments (interest rate “locks”) extended to mortgage
applicants.
Interest rates affect the amount and timing of origination and
servicing fees because consumer demand for new 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. At December 31, 2008, we
measured at fair value similar MHFS acquired from Wachovia.
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 2009 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
2010, we have 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. Consistent with our
longstanding approach to hedging interest rate risk in the
mortgage business, the size of the hedge and the particular
combination of forward 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 2010, 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
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