Wells Fargo 2010 Annual Report Download - page 80

Risk Management –Asset/Liability Management (continued)
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 a flat
or inverted yield curve can result in lower or potentially negative
carry income. The level of carry income is also affected by the
type of instrument used. In general, mortgage forward contracts
tend to produce higher carry income than interest rate swap
contracts. Carry income is recognized over the life of the
mortgage forward as a component of the contract’s mark to
market gain or loss.
Hedging the various sources of interest rate risk in mortgage
banking is a complex process that requires sophisticated
modeling and constant monitoring. While we attempt to balance
these various aspects of the mortgage business, there are several
potential risks to earnings:
• Valuation changes for MSRs associated with interest rate
changes are recorded in earnings immediately within the
accounting period in which those interest rate changes
occur, whereas the impact of those same changes in interest
rates on origination and servicing fees occur with a lag and
over time. Thus, the mortgage business could be protected
from adverse changes in interest rates over a period of time
on a cumulative basis but still display large variations in
income from one accounting period to the next.
• The degree to which the “natural business hedge” offsets
valuation changes for MSRs is imperfect, varies at different
points in the interest rate cycle, and depends not just on the
direction of interest rates but on the pattern of quarterly
interest rate changes.
• Origination volumes, the valuation of MSRs and hedging
results and associated costs are also affected by many
factors. Such factors include the mix of new business
between ARMs and fixed-rate mortgages, the relationship
between short-term and long-term interest rates, the degree
of volatility in interest rates, the relationship between
mortgage interest rates and other interest rate markets, and
other interest rate factors. Many of these factors are hard to
predict 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 ARMs 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, the
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 $15.9 billion and $17.1 billion at December 31, 2010
and 2009, respectively. The weighted-average note rate on our
portfolio of loans serviced for others was 5.39% and 5.66% at
December 31, 2010 and 2009, respectively. Our total MSRs were
0.86% of mortgage loans serviced for others at
December 31, 2010, compared with 0.91% at
December 31, 2009.
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 in 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 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 From a market risk
perspective, our net income is exposed to changes in interest
rates, credit spreads, foreign exchange rates, equity and
commodity prices and their implied volatilities. The primary
purpose of our trading businesses is to accommodate customers
in the management of their market price risks. Also, we take
positions based on market expectations or to benefit from price
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