Wells Fargo 2012 Annual Report Download - page 113

housing slowdown and greater than expected deterioration in
residential real estate values in many markets, including the
Central Valley California market and several Southern California
metropolitan statistical areas. As California is our largest
banking state in terms of loans and deposits, deterioration in real
estate values and underlying economic conditions in those
markets or elsewhere in California could result in materially
higher credit losses. In addition, deterioration in macro-
economic conditions generally across the country could result in
materially higher credit losses, including for our residential real
estate loan portfolio. We may experience higher delinquencies
and higher loss rates as our consumer real estate secured lines of
credit reach their contractual end of draw period and begin to
amortize.
We are currently the largest CRE lender in the U.S. A
deterioration in economic conditions that negatively affects the
business performance of our CRE borrowers, including increases
in interest rates and/or declines in commercial property values,
could result in materially higher credit losses and have a material
adverse effect on our financial results and condition.
The European debt crisis, which has resulted in deteriorating
economic conditions in Europe and ratings agency downgrades
of the sovereign debt ratings of several European countries, has
increased foreign credit risk. Although our foreign loan exposure
represented only approximately 5% of our total consolidated
outstanding loans and 3% of our total assets at
December 31, 2012, continued European economic difficulties
could indirectly have a material adverse effect on our credit
performance and results of operations and financial condition to
the extent it negatively affects the U.S. economy and/or our
borrowers who have foreign operations.
For more information, refer to the “Risk Management –
Credit Risk Management” section and Note 6 (Loans and
Allowance for Credit Losses) to Financial Statements in this
Report.
We may incur losses on loans, securities and other
acquired assets of Wachovia that are materially greater
than reflected in our fair value adjustments. We
accounted for the Wachovia merger under the purchase method
of accounting, recording the acquired assets and liabilities of
Wachovia at fair value. All PCI loans acquired in the merger were
recorded at fair value based on the present value of their
expected cash flows. We estimated cash flows using internal
credit, interest rate and prepayment risk models using
assumptions about matters that are inherently uncertain. We
may not realize the estimated cash flows or fair value of these
loans. In addition, although the difference between the pre-
merger carrying value of the credit-impaired loans and their
expected cash flows – the “nonaccretable difference” – is
available to absorb future charge-offs, we may be required to
increase our allowance for credit losses and related provision
expense because of subsequent additional credit deterioration in
these loans.
For more information, refer to the “Critical Accounting
Policies – Purchased Credit-Impaired (PCI) Loans” and “Risk
Management – Credit Risk Management” sections in this Report.
Our mortgage banking revenue can be volatile from
quarter to quarter, including as a result of changes in
interest rates and the value of our MSRs and MHFS,
and we rely on the GSEs to purchase our conforming
loans to reduce our credit risk and provide liquidity to
fund new mortgage loans. We were the largest mortgage
originator and residential mortgage servicer in the U.S. as of
December 31, 2012, and we earn revenue from fees we receive for
originating mortgage loans and for servicing mortgage loans. As
a result of our mortgage servicing business, we have a sizeable
portfolio of MSRs. An MSR is the right to service a mortgage loan
– collect principal, interest and escrow amounts – for a fee. We
acquire MSRs when we keep the servicing rights after we sell or
securitize the loans we have originated or when we purchase the
servicing rights to mortgage loans originated by other lenders.
We initially measure and carry all our residential MSRs using the
fair value measurement method. Fair value is the present value
of estimated future net servicing income, calculated based on a
number of variables, including assumptions about the likelihood
of prepayment by borrowers. Changes in interest rates can affect
prepayment assumptions and thus fair value. When interest rates
fall, borrowers are usually more likely to prepay their mortgage
loans by refinancing them at a lower rate. As the likelihood of
prepayment increases, the fair value of our MSRs can decrease.
Each quarter we evaluate the fair value of our MSRs, and any
decrease in fair value reduces earnings in the period in which the
decrease occurs. We also measure at fair value prime MHFS for
which an active secondary market and readily available market
prices exist. In addition, we measure at fair value certain other
interests we hold related to residential loan sales and
securitizations. Similar to other interest-bearing securities, the
value of these MHFS and other interests may be negatively
affected by changes in interest rates. For example, if market
interest rates increase relative to the yield on these MHFS and
other interests, their fair value may fall.
When rates rise, the demand for mortgage loans usually tends
to fall, reducing the revenue we receive from loan originations.
Under the same conditions, revenue from our MSRs can increase
through increases in fair value. When rates fall, mortgage
originations usually tend to increase and the value of our MSRs
usually tends to decline, also with some offsetting revenue effect.
Even though they can act as a “natural hedge,” the hedge is not
perfect, either in amount or timing. For example, the negative
effect on revenue from a decrease in the fair value of residential
MSRs is generally immediate, but any offsetting revenue benefit
from more originations and the MSRs relating to the new loans
would generally accrue over time. It is also possible that, because
of economic conditions and/or a weak or deteriorating housing
market similar to current market conditions, even if interest
rates were to fall or remain low, mortgage originations may also
fall or any increase in mortgage originations may not be enough
to offset the decrease in the MSRs value caused by the lower
rates.
We typically use derivatives and other instruments to hedge
our mortgage banking interest rate risk. We generally do not
hedge all of our risk, and we may not be successful in hedging
any of the risk. Hedging is a complex process, requiring
sophisticated models and constant monitoring, and is not a
111