Portfolio of 33
Wells Fargo: The Sunny Side of Hedge Ineffectiveness
By Ed Rombach

How Wells Fargo's hedge selection benefits from current climate.

Recent media coverage of deflationary indicators like the recent CPI announcement of -.3% in October has prompted some analysts to differentiate between "bad" deflation caused by monetary policy mistakes and "good" deflation attributable to increases in labor productivity. Similarly, when it comes to risk management as practiced in accordance with FAS 133, a case can be made for differentiating between "bad" and "good" hedge ineffectiveness. Since the beginning of the year, with the most aggressive Federal Reserve rate cutting in memory, financial institutions involved in mortgage originations, securitization and retention of mortgage servicing rights (MRS) have been consistently the most prone to reporting significant hedge ineffectiveness. As the Fed cut the over night funds rate another 100 basis points during the third quarter, Wells Fargo & Co, which is included in the Portfolio of '33' took the prize for hedge ineffectiveness - the good kind.

A windfall
Specifically, Wells Fargo recognized a gain of $320 million for the third quarter in non-interest income, representing the ineffective portion of fair value hedges of mortgage servicing rights. This excess hedging gain boosted quarterly EPS by $.19 to $.68, accounting for over 23% of third quarter earnings. If only hedge ineffectiveness was always so kind.

How did Wells Fargo manage to rack up such robust fair value hedging gains relative to their mortgage servicing rights? Did they over hedge, or did the actual prepayment speed of home mortgage re-financing turn out to be less than anticipated? Perhaps it was a little bit of both.

Wells Fargos's third quarter 10Q provides some insights about their hedging methodology, indicating that the ineffectiveness windfall was primarily related to yield curve and basis spread changes that impacted favorably on the derivative hedges relative to the hedged exposures in the volatile interest rate environment.

Divergent spread movement
Subsequent, to June 30 and especially after the September 11 attacks, swap spreads were volatile but generally tended to narrow in the falling interest rate environment, as ten-year swap spreads narrowed from 90 basis points on 7/2/01 to 63 basis points on 9/28/01. If the bank had used Treasury instruments to hedge the prepayment risk on its MRS assets instead of LIBOR based products, the hedges would have under performed. However, Wells Fargo's third quarter 10Q discloses that the company uses a variety of derivatives to hedge the fair value of their MSR portfolio including futures, floors, forwards, swaps and options indexed to LIBOR.

The yield curve steepens
Moreover, the yield curve continued to steepen during the third quarter with the yield spread between ten and thirty year Treasuries widening from 33 basis points out to 88 basis points while the spread between 10yr and 30yr LIBOR swap rates widened from 28 basis points to 65 basis points. Since the ten-year maturity is the duration of choice for mortgage hedgers, it follows that these hedges would have out performed hedges with longer durations.

In connection with this, the company reported that all the components of each derivative instrument's gain or loss used for hedging mortgage servicing rights were included in the measurement of hedge ineffectiveness and was reflected in the statement of income. However, time decay (theta) and the volatility components (vega) pertaining to changes in time value of options were excluded in the assessment of hedge effectiveness. As of September 30, 2001, all designated hedges continued to qualify as fair value hedges. In addition, all components of each derivative instrument's gain or loss used to convert long term fixed rate debt into floating rate debt were also included in the assessment of hedge effectiveness.

Ineffectiveness cuts both ways
There was also some of the bad kind of hedge ineffectiveness which showed up in Wells Fargo's cash flow hedges which include futures contracts and mandatory forward contracts, including options on futures and forward contracts, all of which are used to hedge the forecasted sale of its mortgage loans. During the third quarter the company recognized a net loss of $54 million (-$.03 per share), accounting for ineffectiveness of these hedges, all component gains and losses of which were included in the assessment of hedge effectiveness.

It would appear that this hedge ineffectiveness was the flip side of the coin of the ineffectiveness on the fair value hedges because the futures contracts most commonly used to hedge this kind of pipeline risk are ten year Treasury note futures which would have tended to under-performed relative to the value of the mortgage loans, given the steepening of the yield curve and the general spread widening of mortgage rates relative to treasuries.

For example, ten year constant maturity treasury yields fell 86 basis points, from 5.44% on 7/5/01 to 4.58% on 9/27/01 in contrast to the Freddie Mac weekly survey of mortgage rates reports average 30-year fixed rate mortgages at 7.19% on 7/05/01 or a spread of 1.75% over the ten-year constant maturity treasury rates, vs. average fixed mortgage rates of 6.72% on 9/27/01 or a spread of 2.14% over ten-year treasury rates.

The net impact of the $320 million of excess gains in the fair value hedges vs. net losses of $54 million in the cash value hedges weighs in at a net hedge ineffectiveness of $271 million or almost $.16 (16 cents) per share courtesy of a Federal Reserve policy cutting interest rates with a vengeance. However, the unprecedented interest rate volatility of this period could well turn this quarter's ineffectiveness windfall into next quarter's shortfall. Risk managers should at least be able to take some comfort though from the fact that the fed can't lower interest rates below zero percent.