UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
Commission file number 001-2979
WELLS FARGO & COMPANY
(Exact name of registrant as specified in its charter)
420 Montgomery Street, San Francisco, California 94163
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: 1-866-249-3302
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yesþ No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes þ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes¨ No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Shares Outstanding
October 31, 2011
CROSS-REFERENCE INDEX
PART I
Item 1.
1 - Summary of Significant Accounting Policies
2 - Business Combinations
3 - Federal Funds Sold, Securities Purchased under Resale Agreements and Other Short-Term Investments
4 - Securities Available for Sale
5 - Loans and Allowance for Credit Losses
6 - Other Assets
7 - Securitizations and Variable Interest Entities
8 - Mortgage Banking Activities
9 - Intangible Assets
10 - Guarantees, Pledged Assets and Collateral
11 - Legal Actions
12 - Derivatives
13 - Fair Values of Assets and Liabilities
14 - Preferred Stock
15 - Employee Benefits
16 - Earnings Per Common Share
17 - Operating Segments
18 - Condensed Consolidating Financial Statements
19 - Regulatory and Agency Capital Requirements
Item 2.
Management’s Discussion and Analysis of Financial Condition andResults of Operations (Financial Review)
Item 3.
Item 4.
PART II
Item 1A.
Item 6.
Signature
Exhibit Index
1
PART I - FINANCIAL INFORMATION
FINANCIAL REVIEW
Summary Financial Data
For the Period
Wells Fargo net income
Wells Fargo net incomeapplicable to common stock
Diluted earnings per common share
Profitability ratios (annualized):
Wells Fargo net income toaverage assets (ROA)
Wells Fargo net income applicable to common stock to average Wells Fargo common stockholders’ equity (ROE)
Efficiency ratio (1)
Total revenue
Pre-tax pre-provision profit (PTPP) (2)
Dividends declared per common share
Average common shares outstanding
Diluted average common shares outstanding
Average loans
Average assets
Average core deposits (3)
Average retail core deposits (4)
Net interest margin
At Period End
Securities available for sale
Loans
Allowance for loan losses
Goodwill
Assets
Core deposits (3)
Wells Fargo stockholders’ equity
Total equity
Tier 1 capital (5)
Total capital (5)
Capital ratios:
Total equity to assets
Risk-based capital (5):
Tier 1 capital
Total capital
Tier 1 leverage (5)
Tier 1 common equity (6)
Common shares outstanding
Book value per common share
Common stock price:
High
Low
Period end
Team members (active, full-time equivalent)
2
This Quarterly Report, including the Financial Review and the Financial Statements and related Notes, contains forward-looking statements, which may include forecasts of our financial results and condition, expectations for our operations and business, and our assumptions for those forecasts and expectations. Do not unduly rely on forward-looking statements. Actual results may differ materially from our forward-looking statements due to several factors. Factors that could cause our actual results to differ materially from our forward-looking statements are described in this Report, including in the “Forward-Looking Statements” and “Risk Factors” sections, as well as in the “Risk Factors” section of our Quarterly Report on Form 10-Q for the period ended June 30, 2011 (2011 Second Quarter Form 10-Q), and the “Regulation and Supervision” section of our Annual Report on Form 10-K for the year ended December 31, 2010 (2010 Form 10-K).
When we refer to “Wells Fargo,” “the Company,” “we,” “our” or “us” in this Report, we mean Wells Fargo & Company and Subsidiaries (consolidated). When we refer to the “Parent,” we mean Wells Fargo & Company. When we refer to “legacy Wells Fargo,” we mean Wells Fargo excluding Wachovia Corporation (Wachovia). See the Glossary of Acronyms at the end of this Report for terms used throughout this Report.
Financial Review
Overview
Wells Fargo & Company is a diversified financial services company with $1.3 trillion in assets. Founded in 1852 and headquartered in San Francisco, we provide banking, insurance, trust and investments, mortgage banking, investment banking, retail banking, brokerage services and consumer and commercial finance through more than 9,000 stores, 12,000 ATMs, the internet and other distribution channels to individuals, businesses and institutions in all 50 states, the District of Columbia (D.C.) and in other countries. With approximately 264,000 active full-time equivalent team members, we serve one in three households in America and ranked No. 23 on Fortune’s 2011 rankings of America’s largest corporations. We ranked fourth in assets and first in the market value of our common stock among our large bank peers at September 30, 2011.
Our Vision and Strategy
Our vision is to satisfy all our customers’ financial needs, help them succeed financially, be recognized as the premier financial services company in our markets and be one of America’s great companies. Our primary strategy to achieve this vision is to increase the number of products our customers buy from us and to offer them all of the financial products that fulfill their needs. Our cross-sell strategy, diversified business model and the breadth of our geographic reach facilitate growth in both strong and weak economic cycles, as we can grow by expanding the number of products our current customers have with us, gain new customers in our extended markets, and increase market share in many businesses.
Our retail bank household cross-sell was 5.91 products per household in third quarter 2011, up from 5.68 a year ago. We believe there is more opportunity for cross-sell as we continue to earn more business from our customers. Our goal is eight products per customer, which is approximately half of our estimate of potential demand for an average U.S. household. One of every four of our retail banking households has eight or more products. Business banking cross-sell offers another potential opportunity for growth, with cross-sell of 4.21 products in our Western footprint in third quarter 2011 (including legacy Wells
Fargo and converted Wachovia customers), up from 3.97 a year ago.
Our pursuit of growth and earnings performance is influenced by our belief that it is important to maintain a well controlled operating environment as we complete the integration of the Wachovia businesses and grow the combined company. We manage our credit risk by establishing what we believe are sound credit policies for underwriting new business, while monitoring and reviewing the performance of our loan portfolio. We manage the interest rate and market risks inherent in our asset and liability balances within established ranges, while ensuring adequate liquidity and funding. We maintain strong capital levels to facilitate future growth.
Expense management is important to us, but we approach this in a manner intended to help ensure our revenue is not adversely affected. Our current company-wide expense management initiative, project Compass, is focused on removing unnecessary complexity and eliminating duplication as a way to improve the customer experience and the work process of our team members. With this initiative and the completion of merger-related activities, we are targeting quarterly noninterest expense of approximately $11 billion by fourth quarter 2012. The target reflects expense savings initiatives that will be executed over the upcoming quarters. Quarterly expense trends may vary due to cyclical or seasonal factors, particularly in the first quarter of each year when higher incentive compensation and employee benefit expenses typically occur. In addition, we will continue to invest in our businesses and add team members where appropriate.
Financial Performance
Our third quarter 2011 results were strong despite continued economic volatility during the period, with solid growth in loans, deposits, investment securities and capital, along with improved credit quality and lower expenses. Wells Fargo net income was a record $4.1 billion in third quarter 2011, up 21% from a year ago, and diluted earnings per common share were $0.72, up 20%. Our net income growth from a year ago was primarily driven by a lower provision for credit losses and lower noninterest
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Overview (continued)
expenses, which more than offset lower revenues. Net income growth from a year ago included contributions from each of our three business segments: Community Banking (up 20%); Wholesale Banking (up 20%); and Wealth, Brokerage and Retirement (up 14%). Return on average assets was 1.26% for third quarter 2011 compared with 1.09% a year ago. Our return on equity was 11.86% this quarter, up from 10.90% a year ago.
On a year-over-year basis, revenue was down 6% in third quarter 2011, reflecting decreased interest income on securities available for sale and loans due to lower yields as market rates declined, a decline in mortgage banking income and lower trading revenue. Noninterest expense was down 5% from a year ago reflecting the benefit of reduced personnel costs, reduced core deposit amortization, reduced integration costs and lower operating losses.
We believe strong loan and deposit growth are positioning us for continued financial performance improvement. Total loans were $760.1 billion at September 30, 2011, up from $757.3 billion at December 31, 2010. The net growth in loans from December 31, 2010, includes a $16.8 billion decrease in our non-strategic and liquidating portfolios. Our average core deposits grew 8% from a year ago to $836.8 billion at September 30, 2011. Average core deposits were 111% of total average loans in third quarter 2011, up from 102% a year ago. We continued to attract high quality core deposits in the form of checking and savings deposits, which on average totaled $769.2 billion, up 12% from a year ago as we added new customers and deepened our relationships with existing customers.
Credit Quality
We continued to experience improvement in our credit portfolio with lower net charge-offs, lower nonperforming assets (NPAs) and stable delinquency trends from second quarter 2011. The rate of improvement moderated in some portfolios in the quarter, consistent with our expectations at this point in the credit cycle. The improvement in our credit portfolio was due in part to the continued decline in balances in our non-strategic and liquidating loan portfolios (primarily from the Wachovia acquisition), which decreased $5.2 billion from second quarter 2011, and $74.3 billion in total since the beginning of 2009, to $116.5 billion at September 30, 2011.
Reflecting the continued improved performance in our loan portfolios, the $1.8 billion provision for credit losses for third quarter 2011 was $1.6 billion less than a year ago. The provision for credit losses was $800 million less than net charge-offs in third quarter 2011 and $650 million less than net charge-offs in the third quarter a year ago. Absent significant deterioration in the economy, we expect future allowance releases. Third quarter 2011 marked the seventh consecutive quarter of decline in net charge-offs and the fourth consecutive quarter of reduced NPAs. Net charge-offs decreased to $2.6 billion in third quarter 2011 from $2.8 billion in second quarter 2011 and $4.1 billion a year ago. NPAs decreased to $26.8 billion at September 30, 2011, from $27.9 billion at June 30, 2011, and $34.4 billion a year ago. Loans 90 days or more past due and still accruing (excluding government insured/guaranteed loans) increased slightly to $1.9 billion at September 30, 2011, from $1.8 billion at June 30, 2011, but decreased from $3.2 billion a year ago. In
addition, the portfolio of purchased credit-impaired (PCI) loans acquired in the Wachovia merger continued to perform better than expected at the time of the merger.
Capital
We continued to build capital in third quarter 2011, with total equity up $11.4 billion to $139.2 billion from December 31, 2010. In third quarter 2011, our Tier 1 common equity ratio grew 19 basis points to 9.34% of risk-weighted assets under Basel I, reflecting strong internal capital generation. Under current Basel III capital proposals, we estimate that our Tier 1 common equity ratio was 7.41% at the end of third quarter 2011. Our other regulatory capital ratios remained strong with a Tier 1 capital ratio of 11.26% and Tier 1 leverage ratio of 8.97% at September 30, 2011. Additional capital requirements applicable to certain systemically important global financial institutions, including Wells Fargo, are under consideration by the Basel Committee. See the “Capital Management” section in this Report for more information regarding our capital, including Tier 1 common equity.
In third quarter 2011 we called for redemption $5.8 billion of trust preferred securities that were redeemed in October 2011, repurchased 22 million shares of our common stock and entered into a $150 million private forward repurchase transaction that will settle in fourth quarter 2011 for an estimated 6 million shares of common stock. We also paid a common stock dividend of $0.12 per share.
Wachovia Merger Integration
On December 31, 2008, Wells Fargo acquired Wachovia, one of the nation’s largest diversified financial services companies. Our integration progress continued to be on track, and business and revenue synergies have exceeded our expectations since the merger was announced. To date we have converted 3,083 Wachovia retail banking stores and over 38 million customer accounts, including mortgage, deposit, trust, brokerage and credit card accounts. With the North Carolina retail bank store conversions completed in October 2011, all our retail bank store conversions are complete. Our remaining integration activities are expected to be completed in first quarter 2012, including certain deposit, brokerage and Wholesale Banking conversion events.
As a result of PCI accounting for loans acquired in the Wachovia merger, the Company’s ratios, including the growth rate in NPAs since December 31, 2008, may not be directly comparable with periods prior to the merger or with credit-related ratios of other financial institutions. In particular:
Wachovia’s high risk loans were written down pursuant to PCI accounting at the time of merger. Therefore, the allowance for credit losses is lower than otherwise would have been required without PCI loan accounting; and
Because we virtually eliminated Wachovia’s nonaccrual loans at December 31, 2008, the quarterly growth rate in our nonaccrual loans following the merger was higher than it would have been without PCI loan accounting. Similarly, our net charge-off rate was lower than it otherwise would have been.
4
Helping Our Customers and the Economy
While the economic recovery remains uneven, we have not wavered from our commitment to do all we can to help our customers and the overall economy. We remain committed to helping homeowners stay in their homes. Since 2009, we have participated in more than 600 home preservation workshops, opened 27 home preservation centers, and arranged over 716,000 active trial or completed mortgage modifications. Within our Pick-a-Pay portfolio alone we have forgiven $4 billion of principal since we acquired this portfolio from Wachovia and modified approximately one-third of our total Pick-a-Pay loans as we strive to give customers an affordable, sustainable payment. As the number one small business lender for nine consecutive years (Community Reinvestment Act government data, 2010), we are committed to helping small businesses succeed by actively lending. We made over $10 billion in new loan commitments to our small business customers in the first nine months of 2011, up 8% from the same period a year ago. We are also the number one lender to mid-sized companies and we have had 14 consecutive months of loan growth to middle market commercial customers.
In addition to serving the financial needs of our business and individual customers, we also help our communities in many other ways. We employ one in every 500 working Americans and last year we contributed $219 million to 19,000 nonprofits across the United States and The Chronicle of Philanthropy named us “America’s Third Most Generous Cash Donor” for 2011. Our team members throughout the country are active volunteers in the communities where they live and work, volunteering over 900,000 hours during the first nine months of 2011.
So, while we are operating in a difficult environment with significant economic and regulatory challenges, we remain focused on helping our customers succeed financially and supporting our communities.
5
Earnings Performance
Wells Fargo net income for third quarter 2011 was $4.1 billion ($0.72 diluted per common share) compared with $3.3 billion ($0.60 diluted per common share) for third quarter 2010. Net income for the first nine months of 2011 was $11.8 billion, up 31% from the same period a year ago. Our September 30, 2011, quarterly and year-to-date earnings, compared with the same periods a year ago, reflected strong execution of our business strategy in a difficult economic environment with a diversified loan portfolio, balanced net interest and fee income, diversified sources of fee income, increased loans and deposits, lower operating costs, improved credit quality and generally higher capital levels.
Revenue, the sum of net interest income and noninterest income, was $19.6 billion in third quarter 2011 compared with $20.9 billion in third quarter 2010. Revenue for the first nine months of 2011 was $60.3 billion, down 5% from the same period a year ago. The decline in revenue in the third quarter and first nine months of 2011 was predominantly due to lower net interest income, mortgage banking and trading revenue. However, many businesses generated double-digit year-over-year quarterly revenue growth, including government and institutional banking, asset-backed finance, commercial real estate, international, debit card, global remittance, asset management, capital finance and real estate capital markets. Net interest income of $10.5 billion in third quarter 2011 declined 5% from a year ago and reflected a 41 basis point decline in the net interest margin and a 1% decline in average loans. The decline in average loans from third quarter 2010 reflected expected reductions in the non-strategic/liquidating portfolios. Continued success in generating low-cost deposits enabled the Company to grow assets by funding loan and securities growth while reducing long-term debt.
Noninterest expense was $11.7 billion (59% of revenue) in third quarter 2011, compared with $12.3 billion (59% of revenue) a year ago. Noninterest expense was $36.9 billion for the first nine months of 2011 compared with $37.1 billion for the same period a year ago. The third quarter and first nine months of 2011 included $376 million and $1.3 billion, respectively, of merger integration costs (down from $476 million in third quarter 2010 and $1.4 billion in the first nine months of 2010), and $780 million and $3.3 billion, respectively, of employee benefits expense (down from $1.1 billion in third quarter 2010 and $3.5 billion in the first nine months of 2010).
Net Interest Income
Net interest income is the interest earned on debt securities, loans (including yield-related loan fees) and other interest-earning assets minus the interest paid for deposits, short-term borrowings and long-term debt. The net interest margin is the average yield on earning assets minus the average interest rate paid for deposits and our other sources of funding. Net interest income and the net interest margin are presented on a taxable-equivalent basis in Table 1 to consistently reflect income from taxable and tax-exempt loans and securities based on a 35% federal statutory tax rate.
Net interest income and the net interest margin are significantly influenced by the mix and overall size of our earning asset portfolio and the cost of funding those assets. In addition, some sources of interest income, such as loan prepayment fees and collection of interest on nonaccrual loans, can vary from period to period. Net interest income on a taxable-equivalent basis was $10.7 billion and $32.4 billion in the third quarter and the first nine months of 2011, compared with $11.3 billion and $34.2 billion, respectively, for the same periods a year ago. The net interest margin was 3.84% and 3.96% in the third quarter and first nine months of 2011, respectively, down from 4.25% and 4.30% for the same periods a year ago. The decline in net interest income and the net interest margin was largely due to repricing of the balance sheet as higher-yielding loan and security runoff was partially offset by investment portfolio purchases and growth in short-term investments. The decline in earning asset income was mitigated by a reduction in funding costs resulting from disciplined deposit pricing, debt maturities, and calls of higher yielding trust preferred securities.
Compared to second quarter 2011, net interest income on a taxable-equivalent basis was down $137 million due to the repricing of the balance sheet. About half of the decline in interest income for securities available for sale was due to runoff offset by new purchases at lower yields. The remainder of the decline was from other sources, including a decline in interest income relating to certain asset-backed securities for which the expected cash flows and resulting yields are adjusted periodically. Within the commercial and industrial loan portfolio more than half of the decline in interest income was from lower variable sources, including prepayment fees and interest recoveries, with the remainder due to repricing of the portfolio offset by the benefit of growth. The majority of the decline in the net interest margin in third quarter 2011 was due to robust deposit growth from June 30, 2011. Much of this growth in deposits was invested in short-term assets, which had the effect of diluting the net interest margin.
Soft consumer loan demand and the impact of liquidating certain loan portfolios reduced average loans in third quarter 2011 to 67% (69% in the first nine months of 2011) of average earning assets from 71% in third quarter 2010 (73% in the first nine months of 2010). Average short-term investments and trading account assets were 12% of earning assets in both the third quarter and first nine months of 2011, up from 9% and 8%, respectively, for the same periods a year ago.
Core deposits are an important low-cost source of funding and thus impact both net interest income and the net interest margin. Core deposits include noninterest-bearing deposits, interest-bearing checking, savings certificates, certain market rate and other savings, and certain foreign deposits (Eurodollar sweep balances). Average core deposits rose to $836.8 billion in third quarter 2011 ($813.9 billion in the first nine months of 2011) from $772.0 billion in third quarter 2010 ($764.3 billion in the first nine months of 2010) and represented funding for average loans of 111% in the third quarter and 108% for the first nine months of 2011 (102% and 98% for the same periods of 2010.) Average core deposits increased to 75% and 74% of
6
average earning assets in the third quarter and first nine months of 2011, respectively compared with 72% for each respective period a year ago. The cost of these deposits declined significantly as the mix shifted from higher cost certificates of deposit to checking and savings products, which were also at lower yields relative to the third quarter and first nine months of 2010. About 92% of our average core deposits are in checking and savings deposits, one of the highest percentages in the industry.
In third quarter 2011, we called for redemption $5.8 billion of trust preferred securities with an average coupon rate of 8.45% that were redeemed in October 2011. Net interest income in fourth quarter 2011 is expected to benefit from the redemption of this high cost funding source.
7
Earnings Performance (continued)
Table 1: Average Balances, Yields and Rates Paid (Taxable-Equivalent Basis) (1)(2)
Average
balance
Yields/
rates
Interest
income/
expense
Earning assets
Federal funds sold, securities purchased under resale agreements and other short-term investments
Trading assets
Securities available for sale (3):
Securities of U.S. Treasury and federal agencies
Securities of U.S. states and political subdivisions
Mortgage-backed securities:
Federal agencies
Residential and commercial
Total mortgage-backed securities
Other debt and equity securities
Total securities available for sale
Mortgages held for sale (4)
Loans held for sale (4)
Loans:
Commercial:
Commercial and industrial
Real estate mortgage
Real estate construction
Lease financing
Foreign
Total commercial
Consumer:
Real estate 1-4 family first mortgage
Real estate 1-4 family junior lien mortgage
Credit card
Other revolving credit and installment
Total consumer
Total loans (4)
Other
Total earning assets
Funding sources
Deposits:
Interest-bearing checking
Market rate and other savings
Savings certificates
Other time deposits
Deposits in foreign offices
Total interest-bearing deposits
Short-term borrowings
Long-term debt
Other liabilities
Total interest-bearing liabilities
Portion of noninterest-bearing funding sources
Total funding sources
Net interest margin and net interest income on a taxable-equivalent basis (5)
Noninterest-earning assets
Cash and due from banks
Total noninterest-earning assets
Noninterest-bearing funding sources
Deposits
Noninterest-bearing funding sources used to fund earning assets
Net noninterest-bearing funding sources
Total assets
8
9
Noninterest Income
Table 2: Noninterest Income
Service charges on deposit accounts
Trust and investment fees:
Trust, investment and IRA fees
Commissions and all other fees
Total trust and investment fees
Card fees
Other fees:
Cash network fees
Charges and fees on loans
Processing and all other fees
Total other fees
Mortgage banking:
Servicing income, net
Net gains on mortgage loan origination/sales activities
Total mortgage banking
Insurance
Net gains (losses) from trading activities
Net gains (losses) on debt securities available for sale
Net gains from equity investments
Operating leases
All other
Total
NM - Not meaningful
Noninterest income was $9.1 billion and $9.8 billion for third quarter 2011 and 2010, respectively, and $28.5 billion and $30.0 billion for the first nine months of 2011 and 2010, respectively. Noninterest income represented 46% of revenue for the quarter and 47% for the nine months ended September 30, 2011. The decrease in total noninterest income in the third quarter and first nine months of 2011 from the same periods a year ago was due largely to lower net gains on mortgage loan origination/sales activities and net losses/lower net gains from trading activities.
Our service charges on deposit accounts decreased 3% in the third quarter and 18% in the first nine months of 2011 from the same periods a year ago, primarily due to changes mandated by Regulation E and related overdraft policy changes.
We earn trust, investment and IRA (Individual Retirement Account) fees from managing and administering assets, including mutual funds, corporate trust, personal trust, employee benefit trust and agency assets. At September 30, 2011, these assets totaled $2.1 trillion, up 5% from $2.0 trillion at September 30, 2010. Trust, investment and IRA fees are largely based on a tiered scale relative to the market value of the assets under management or administration. These fees increased to $1.0 billion in third quarter 2011 from $924 million a year ago and increased to $3.1 billion for the first nine months of 2011 from $3.0 billion a year ago.
We receive commissions and other fees for providing services to full-service and discount brokerage customers as well as from
investment banking activities including equity and bond underwriting. These fees increased to $1.8 billion in third quarter 2011 from $1.6 billion a year ago and increased to $5.5 billion for the first nine months of 2011 from $5.0 billion a year ago. These fees include transactional commissions, which are based on the number of transactions executed at the customer’s direction, and asset-based fees, which are based on the market value of the customer’s assets. Brokerage client assets totaled $1.1 trillion at September 30, 2011 and 2010.
Card fees increased to $1.0 billion in third quarter 2011, from $935 million in third quarter 2010. For the first nine months of 2011, these fees increased to $3.0 billion from $2.7 billion a year ago. The increase was mainly due to growth in purchase volume and new accounts growth. Based on the final FRB rules regarding debit card interchange fees, we currently estimate a quarterly reduction in earnings of approximately $250 million (after tax), before the impact of any mitigating actions, starting in fourth quarter 2011. We currently expect future volume, product or account changes may mitigate at least half of this earnings reduction over time.
Mortgage banking noninterest income, consisting of net servicing income and net gains on loan origination/sales activities, totaled $1.8 billion in third quarter 2011, compared with $2.5 billion a year ago and totaled $5.5 billion for the first nine months of 2011 compared with $7.0 billion for the same period a year ago. The reduction year over year in mortgage banking noninterest income was primarily driven by a decline in
10
net gains on mortgage loan origination/sales activities as explained below.
Net mortgage loan servicing income includes both changes in the fair value of mortgage servicing rights (MSRs) during the period as well as changes in the value of derivatives (economic hedges) used to hedge the MSRs. Net servicing income for third quarter 2011 included a $607 million net MSR valuation gain ($2.64 billion decrease in the fair value of the MSRs offset by a $3.25 billion hedge gain) and for third quarter 2010 included a $56 million net MSR valuation gain ($1.1 billion decrease in the fair value of MSRs offset by a $1.2 billion hedge gain). For the first nine months of 2011, it included a $1.4 billion net MSR valuation gain ($3.22 billion decrease in the fair value of MSRs offset by a $4.58 billion hedge gain) and for the same period of 2010, included a $1.7 billion net MSR valuation gain ($4.57 billion decrease in the fair value of MSRs offset by a $6.24 billion hedge gain). See the “Risk Management – Mortgage Banking Interest Rate and Market Risk” section of this Report for additional information regarding our MSRs risks and hedging approach. The valuation of our MSRs at the end of third quarter 2011 reflected our assessment of expected future levels in servicing and foreclosure costs, including the estimated impact from regulatory consent orders. See the “Risk Management – Credit Risk Management – Risks Relating to Servicing Activities” section in this Report for information on the regulatory consent orders. Our portfolio of loans serviced for others was $1.86 trillion at September 30, 2011, and $1.84 trillion at December 31, 2010. At September 30, 2011, the ratio of MSRs to related loans serviced for others was 0.74%, compared with 0.86% at December 31, 2010.
Income from loan origination/sale activities was $803 million and $2.7 billion in the third quarter and first nine months of 2011, respectively, down from $2.0 billion and $3.9 billion for the same periods a year ago. The year over year decreases were driven by lower loan origination volume and margins. Residential real estate originations were $89 billion in third quarter 2011 compared with $101 billion a year ago and mortgage applications were $169 billion in third quarter 2011 compared with $194 billion a year ago. The 1-4 family first mortgage unclosed pipeline was $84 billion at September 30, 2011, and $101 billion a year ago. For additional information, see the “Risk Management – Mortgage Banking Interest Rate and Market Risk” section and Note 8 (Mortgage Banking Activities) and Note 13 (Fair Values of Assets and Liabilities) to Financial Statements in this Report.
Net gains on mortgage loan origination/sales activities include the cost of any additions to the mortgage repurchase liability. Mortgage loans are repurchased from third parties based on standard representations and warranties, and early payment default clauses in mortgage sale contracts. Additions to the mortgage repurchase liability that were charged against net gains on mortgage loan origination/sales activities during third quarter 2011 totaled $390 million (compared with $370 million for third quarter 2010), of which $371 million ($341 million for third quarter 2010) was for subsequent increases in estimated losses on prior period loan sales. Additions to the mortgage repurchase liability for the nine months ended September 30, 2011, and 2010 were $881 million and $1.2 billion, respectively,
of which $807 million and $1.0 billion, respectively, were for subsequent increases in estimated losses on prior period loan sales. For additional information about mortgage loan repurchases, see the “Risk Management – Credit Risk Management – Liability for Mortgage Loan Repurchase Losses” section in this Report.
Net gains (losses) from trading activities, which reflect unrealized and realized changes in fair value of our trading positions, were net losses of $442 million and net gains of $584 million in the third quarter and first nine months of 2011, respectively, compared with net gains of $470 million and $1.1 billion for the same periods a year ago. The year-over-year decreases for the third quarter and first nine months of 2011 were driven by weaker trading results as consistent negative economic data, sovereign debt concerns and the U.S. debt downgrade pressured credit spreads and reduced prices on financial assets, significantly curtailing new issue origination and trading opportunities. Also included in third quarter 2011 was a $377 million loss associated with a legacy Wachovia position that settled in October 2011. This loss was primarily due to widening in credit spreads. Trading activities during third quarter 2011 also included an unrealized loss on deferred compensation plan investments of $234 million, which corresponded with a reduction in employee benefits expense. Net gains (losses) from trading activities do not include interest income and other fees earned from related activities. Those amounts are reported within interest income from trading assets and other fees within noninterest income line items of the income statement. Net gains (losses) from trading activities are primarily from trading performed on behalf of or driven by the needs of our customers (customer accommodation trading) and also include the results of certain economic hedging and proprietary trading activity. Net losses from proprietary trading totaled $9 million and $18 million in the third quarter and first nine months of 2011, respectively, compared with $45 million and $32 million for the same periods a year ago. These net proprietary trading losses were offset by interest and fees reported in their corresponding income statement line items. Proprietary trading activities are not significant to our client-focused business model. Our trading activities and what we consider to be customer accommodation, economic hedging and proprietary trading are further discussed in the “Asset/Liability Management – Market Risk – Trading Activities” section in this Report.
Net gains on debt and equity securities totaled $644 million for third quarter 2011 and $17 million for third quarter 2010, after other-than-temporary impairment (OTTI) write-downs of $144 million and $179 million for the same periods, respectively. Included in net gains on debt securities during third quarter 2011 was a $271 million gain related to a legacy Wachovia position, due to redemption of our interest in an investment fund.
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Noninterest Expense
Table 3: Noninterest Expense
Salaries
Commission and incentive compensation
Employee benefits
Equipment
Net occupancy
Core deposit and other intangibles
FDIC and other deposit assessments
Outside professional services
Contract services
Foreclosed assets
Operating losses
Outside data processing
Postage, stationery and supplies
Travel and entertainment
Advertising and promotion
Telecommunications
Noninterest expense was $11.7 billion in third quarter 2011, down 5% from $12.3 billion a year ago, driven by lower total personnel expense ($6.6 billion, down from $6.8 billion in third quarter 2010), lower merger costs ($376 million, down from $476 million a year ago) and lower operating losses ($198 million, down from $230 million in third quarter 2010). For the first nine months of 2011, noninterest expense was essentially flat compared with the same period a year ago.
Personnel expenses were down 4% for third quarter 2011 compared with the same quarter last year. Included in personnel expenses was a $294 million decline in employee benefits due primarily to lower deferred compensation expense which was offset entirely with an unrealized loss on deferred compensation plan investments included in income from trading activities. Personnel expenses were up 2%, however, for the first nine months of 2011 compared with the same period of 2010, primarily due to higher variable compensation paid in first quarter 2011 by businesses with revenue-based compensation, including brokerage.
Outside professional services included increased investments by our businesses this year in their service delivery systems.
Operating losses of $198 million in third quarter 2011 were down from $230 million in third quarter 2010, which was elevated predominantly due to additional accruals for litigation matters.
Merger integration costs totaled $376 million and $476 million in third quarter 2011 and 2010, respectively, and $1.3 billion and $1.4 billion for the first nine months of 2011 and 2010, respectively. The integration of Wachovia remained on track, and with the successful North Carolina conversion in October 2011, all retail banking store conversions are complete.
Remaining integration activities are expected to be concluded by first quarter 2012.
We are pleased with our positive operating leverage and the progress we’ve made on our Compass expense management initiative. Future quarterly expenses are expected to fluctuate as our Compass initiative proceeds toward our target of $11 billion of noninterest expense for fourth quarter 2012. The target reflects expense savings initiatives that will be executed over the next five quarters. Quarterly expense trends may vary due to cyclical or seasonal factors, particularly in the first quarter of each year when higher incentive compensation and employee benefit expenses typically occur. We currently expect fourth quarter 2011 expenses to be higher than third quarter driven by costs associated with the strong mortgage pipeline, higher merger integration expenses and seasonally higher expenses at year end.
Income Tax Expense
Our effective tax rate was 33.0% and 34.4% in third quarter 2011 and 2010, respectively, and 32.1% and 34.3 % for the first nine months of 2011 and 2010, respectively. The lower effective tax rate in third quarter 2011 is primarily related to a decrease in tax expense associated with leveraged leases. In addition to the item affecting the tax rate for third quarter 2011, the decrease in the effective tax rate for the first nine months of 2011 included tax benefits from the realization for tax purposes of a previously written down investment, as well as tax benefits related to charitable donations of appreciated securities.
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Operating Segment Results
We are organized for management reporting purposes into three operating segments: Community Banking; Wholesale Banking; and Wealth, Brokerage and Retirement. These segments are defined by product type and customer segment and their results are based on our management accounting process, for which there is no comprehensive, authoritative guidance equivalent to generally accepted accounting principles (GAAP) for financial accounting. In fourth quarter 2010, we aligned certain lending businesses into Wholesale Banking from Community Banking to
reflect our previously announced restructuring of Wells Fargo Financial. In first quarter 2011, we realigned a private equity business into Wholesale Banking from Community Banking. Prior periods have been revised to reflect these changes. Table 4 and the following discussion present our results by operating segment. For a more complete description of our operating segments, including additional financial information and the underlying management accounting process, see Note 17 (Operating Segments) to Financial Statements in this Report.
Table 4: Operating Segment Results – Highlights
Quarter ended September 30,
Revenue
Net income
Average core deposits
Nine months ended September 30,
Community Banking offers a complete line of diversified financial products and services for consumers and small businesses including investment, insurance and trust services in 39 states and D.C., and mortgage and home equity loans in all 50 states and D.C. through its Regional Banking and Wells Fargo Home Mortgage business units.
Community Banking reported net income of $2.3 billion and revenue of $12.5 billion in third quarter 2011 and $6.6 billion and $37.7 billion, respectively, for the first nine months of 2011. Revenue decreased $951 million, or 7%, from third quarter 2010 largely due to lower mortgage banking income, as well as expected reductions in the liquidating loan portfolios and lower yielding investment security purchases, partially offset by long-term debt runoff, lower deposit costs, equity gains and debit card transaction growth. Revenue for the first nine months of 2011 decreased $3.3 billion, or 8%, compared with the same period a year ago and also reflects lower deposit servicing income as a result of the 2010 implementation of Regulation E. Net interest income decreased $554 million, or 7%, from third quarter 2010 and decreased $2.0 billion, or 8%, for the first nine months of 2011 compared with the same period a year ago, mostly due to lower average loans (down $31.2 billion for the third quarter and $35.9 billion year-to-date) as a result of planned run-off (including Home Equity and Pick-A-Pay) combined with softer loan demand, and a shift in the mix of earning assets towards lower-yielding investment securities portfolios. This decline in interest income was mitigated by continued low funding costs. Average core deposits increased $19.2 billion, or 4%, from third quarter 2010, and $18.5 billion, or 3%, for the first nine months of 2011 compared with the same period a year ago, as growth in liquid deposits more than offset
planned run-off of higher-priced certificates of deposit. We generated strong growth in the number of consumer checking accounts (up a net 5.6% from third quarter 2010).
Noninterest expense decreased $432 million, or 6%, from third quarter 2010 and $292 million, or 1%, for the first nine months of 2011 compared with the same period a year ago, due to reduced expenses across most categories, led by personnel costs including FTE reductions. The provision for credit losses decreased $1.2 billion from third quarter 2010 and $5.1 billion for the first nine months of 2011 compared with the same period a year ago, as credit quality indicators in most of our consumer and business loan portfolios continued to improve. Charge-offs decreased $1.1 billion from third quarter 2010 and $3.8 billion for the first nine months of 2011 compared with the same periods a year ago, showing improvement primarily in the home equity, credit card, and small business lending portfolios. Additionally, we released $450 million of the allowance in third quarter 2011 and $2.0 billion during the first nine months of 2011, compared with $400 million and $789 million, respectively, released during the same periods a year ago.
Wholesale Banking provides financial solutions across the U.S. and globally to middle market and large corporate customers with annual revenue generally in excess of $20 million. Products and businesses include commercial banking, investment banking and capital markets, securities investment, government and institutional banking, corporate banking, commercial real estate, treasury management, capital finance, international, insurance, real estate capital markets, commercial mortgage servicing, corporate trust, equipment finance, asset backed finance, and asset management.
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Wholesale Banking reported net income of $1.8 billion in third quarter 2011, up $301 million, or 20%, from third quarter 2010. Net income increased to $5.4 billion for the first nine months of 2011 from $4.2 billion a year ago. The year over year increases in net income for the third quarter and first nine months were the result of decreases in the provision for credit losses and noninterest expenses more than offsetting decreases in revenue. Revenue in third quarter 2011 decreased $238 million, or 4%, from third quarter 2010 as broad-based growth among many businesses, including strong loan and deposit growth was offset by lower PCI resolutions, a trading loss associated with a legacy Wachovia position, and weakness in fixed income sales and trading and investment banking. Revenue decreased $344 million, or 2%, for the first nine months of 2011 compared with the same period a year ago, as broad-based growth among many businesses, including strong loan and deposit growth, was offset by lower PCI resolutions, crop insurance underwriting income and trading portfolio income. Average loans of $253.4 billion in third quarter 2011 increased 11% from third quarter 2010 driven by increases across most lending areas. Average core deposits of $209.3 billion in third quarter 2011 increased 23% from third quarter 2010, reflecting continued strong customer liquidity. Noninterest expense in third quarter 2011 decreased $30 million, or 1%, from third quarter 2010 primarily related to lower personnel expenses. Noninterest expense decreased $22 million for the first nine months of 2011 compared with the same period a year ago as lower operating losses and foreclosed asset expenses were partially offset by higher personnel expense. The provision for credit losses in third quarter 2011 declined $458 million from third quarter 2010, and included a $350 million allowance release compared with a $250 million release a year ago along with a $358 million improvement in net credit losses. The provision for credit losses declined $1.9 billion for the first nine months of 2011 compared with the same period a year ago, and included an $800 million allowance release compared with a $361 million release a year ago along with a $1.4 billion improvement in net credit losses.
Wealth, Brokerage and Retirement provides a full range of financial advisory services to clients using a planning approach to meet each client’s needs. Wealth Management provides affluent and high net worth clients with a complete range of wealth management solutions including financial planning, private banking, credit, investment management and trust. Family Wealth meets the unique needs of the ultra high net
worth customers. Brokerage serves customers’ advisory, brokerage and financial needs as part of one of the largest full-service brokerage firms in the United States. Retirement is a national leader in providing institutional retirement and trust services (including 401(k) and pension plan record keeping) for businesses, retail retirement solutions for individuals, and reinsurance services for the life insurance industry.
Wealth, Brokerage and Retirement reported net income of $291 million in third quarter 2011, up $35 million, or 14%, from third quarter 2010. Net income increased to $963 million for the first nine months of 2011 from $808 million a year ago. Revenue of $2.9 billion was down 1% for third quarter 2011 compared with the same quarter a year ago and predominantly consisted of brokerage commissions, asset-based fees and net interest income. Revenue increased $434 million, or 5%, for the first nine months of 2011 compared with the same period a year ago, as higher asset-based fees were partially offset by losses on deferred compensation plan investments (offset in expense) and lower brokerage transaction revenue. Net interest income increased $31 million, or 5%, in third quarter 2011 and $70 million, or 3%, for the first nine months of 2011 compared with the same periods a year ago due to higher investment income and the impact of deposit balance growth. Average core deposits of $133.4 billion in third quarter 2011 increased 11% from third quarter 2010. Noninterest income decreased $56 million, or 3%, from third quarter 2010 due to losses on deferred compensation plan investments (offset in expense), as well as lower securities gains in the brokerage business and reduced brokerage transaction revenue. Noninterest income increased $364 million, or 5%, for the first nine months of 2011 compared with the same period a year ago, as higher asset-based fees exceeded losses on deferred compensation plan investments (offset in expense) and lower brokerage transaction revenue. Noninterest expense decreased $52 million, or 2%, from third quarter 2010 primarily due to lower deferred compensation, partially offset by growth in personnel cost largely due to increased broker commissions, driven by higher production levels, and increased non-personnel costs. Noninterest expense increased $254 million, or 4%, for the first nine months of 2011 compared with the same period a year ago, primarily due to growth in personnel cost driven by higher broker commissions offset by lower deferred compensation. The provision for credit losses decreased $29 million, or 38%, in third quarter 2011 and $71 million, or 32%, in the first nine months of 2011 compared with the same periods a year ago due to lower loan net charge-offs.
Balance Sheet Analysis
At September 30, 2011, our total loans and core deposits were up from December 31, 2010. At September 30, 2011, core deposits funded 112% of the loan portfolio, and we have significant capacity to add higher yielding earning assets to generate future revenue and earnings growth. The strength of our business model produced record earnings and high rates of internal capital generation as reflected in our improved capital ratios. Tier 1 capital increased to 11.26% as a percentage of total risk-weighted assets, and Tier 1 common equity to 9.34% at
September 30, 2011, up from 11.16% and 8.30%, respectively, at December 31, 2010. Total capital was 14.86% and Tier 1 leverage was 8.97%, compared with 15.01% and 9.19%, respectively, at December 31, 2010.
The following discussion provides additional information about the major components of our balance sheet. Information about changes in our asset mix and about our capital is included in the “Earnings Performance – Net Interest Income” and “Capital Management” sections of this Report.
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Securities Available for Sale
Table 5: Securities Available for Sale – Summary
Debt securities available for sale
Marketable equity securities
Table 5 presents a summary of our securities available-for-sale portfolio. Securities available for sale consist of both debt and marketable equity securities. We hold debt securities available for sale primarily for liquidity, interest rate risk management and long-term yield enhancement. Accordingly, this portfolio consists primarily of very liquid, high quality federal agency debt and privately issued MBS. The total net unrealized gains on securities available for sale were $6.8 billion at September 30, 2011, down from net unrealized gains of $8.3 billion at December 31, 2010, primarily due to widening credit spreads.
We analyze securities for OTTI quarterly or more often if a potential loss-triggering event occurs. Of the $470 million OTTI write-downs recognized in the first nine months of 2011, $365 million related to debt securities. There were $16 million in OTTI write-downs for marketable equity securities and there were $89 million in OTTI write-downs related to nonmarketable equity securities. For a discussion of our OTTI accounting policies and underlying considerations and analysis see Note 1 (Summary of Significant Accounting Policies – Securities) in our 2010 Form 10-K and Note 4 (Securities Available for Sale) to Financial Statements in this Report.
At September 30, 2011, debt securities available for sale included $27 billion of municipal bonds, of which 81% were rated “A-” or better based on external and, in some cases, internal ratings. Additionally, some of these bonds are guaranteed against loss by bond insurers. These bonds are predominantly investment grade and were generally underwritten in accordance with our own investment standards prior to the determination to purchase, without relying on the bond insurer’s guarantee in making the investment decision. These municipal bonds will continue to be monitored as part of our ongoing impairment analysis of our securities available for sale.
The weighted-average expected maturity of debt securities available for sale was 4.9 years at September 30, 2011. Because 59% of this portfolio is MBS, the expected remaining maturity may differ from contractual maturity because borrowers generally have the right to prepay obligations before the underlying mortgages mature. The estimated effect of a 200 basis point increase or decrease in interest rates on the fair value and the expected remaining maturity of the MBS available for sale are shown in Table 6.
Table 6: Mortgage-Backed Securities
At September 30, 2011
At September 30, 2011,
assuming a 200 basis point:
Increase in interest rates
Decrease in interest rates
See Note 4 (Securities Available for Sale) to Financial Statements in this Report for securities available for sale by security type.
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Balance Sheet Analysis (continued)
Loan Portfolio
Total loans were $760.1 billion at September 30, 2011, up $2.8 billion from December 31, 2010. Increased balances in many commercial loan portfolios predominantly offset the continued reduction in the non-strategic and liquidating portfolios, which have declined $16.8 billion since December 31, 2010. Included in the growth of loans from year
end 2010 was the purchase of $1.1 billion of loans from Bank of Ireland, which were all U.S.-based and largely commercial real estate. Additional information on the non-strategic and liquidating portfolios is included in Table 11 in the “Credit Risk Management” section of this Report.
Table 7: Loan Portfolios
Commercial
Consumer
Total loans
A discussion and comparative detail of average loan balances are included in Table 1 under “Earnings Performance – Net Interest Income” earlier in this Report. Additional information on total loans outstanding by portfolio segment and class of financing receivable is included in the “Credit Risk Management” section in this Report. Period-end balances and other loan related information are in Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
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Deposits totaled $895.4 billion at September 30, 2011, compared with $847.9 billion at December 31, 2010, reflecting flight to quality activity during third quarter 2011 and new account growth. Table 8 provides additional information regarding deposits. Comparative detail of average deposit
balances is provided in Table 1 under “Earnings Performance – Net Interest Income” earlier in this Report. Total core deposits were $849.6 billion at September 30, 2011, up $51.4 billion from $798.2 billion at December 31, 2010.
Table 8: Deposits
Noninterest-bearing
Foreign deposits (1)
Core deposits
Other time and savings deposits
Other foreign deposits
Total deposits
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Fair Valuation of Financial Instruments
We use fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. See our 2010 Form 10-K for a description of our critical accounting policy related to fair valuation of financial instruments.
We may use independent pricing services and brokers to obtain fair values based on quoted prices. We determine the most appropriate and relevant pricing service for each security class and generally obtain one quoted price for each security. For certain securities, we may use internal traders to obtain estimated fair values, which are subject to our internal price verification procedures. We validate prices received using a variety of methods, including, but not limited to, comparison to pricing services, corroboration of pricing by reference to other independent market data such as secondary broker quotes and relevant benchmark indices, and review of pricing by Company personnel familiar with market liquidity and other market-related conditions.
Table 9 presents the summary of the fair value of financial instruments recorded at fair value on a recurring basis, and the amounts measured using significant Level 3 inputs (before derivative netting adjustments). The fair value of the remaining assets and liabilities were measured using valuation methodologies involving market-based or market-derived information, collectively Level 1 and 2 measurements.
Table 9: Fair Value Level 3 Summary
Assets carried at fair value
As a percentage of total assets
Liabilities carried at fair value
As a percentage of total liabilities
See Note 13 (Fair Values of Assets and Liabilities) to Financial Statements in this Report for additional information regarding our use of fair valuation of financial instruments, our related measurement techniques and the impact to our financial statements.
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Off-Balance Sheet Arrangements
In the ordinary course of business, we engage in financial transactions that are not recorded in the balance sheet, or may be recorded in the balance sheet in amounts that are different from the full contract or notional amount of the transaction. These transactions are designed to (1) meet the financial needs of customers, (2) manage our credit, market or liquidity risks, (3) diversify our funding sources, and/or (4) optimize capital.
Off-Balance Sheet Transactions with Unconsolidated Entities
We routinely enter into various types of on- and off-balance sheet transactions with special purpose entities (SPEs), which are corporations, trusts or partnerships that are established for a limited purpose. Historically, the majority of SPEs were formed in connection with securitization transactions. For more information on securitizations, including sales proceeds and cash flows from securitizations, see Note 7 (Securitizations and Variable Interest Entities) to Financial Statements in this Report.
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Risk Management
All financial institutions must manage and control a variety of business risks that can significantly affect their financial performance. Key among those are credit, asset/liability and market risk.
For more information about how we manage these risks, see the “Risk Management” section in our 2010 Form 10-K. The discussion that follows is intended to provide an update on these risks.
Credit Risk Management
Table 10: Total Loans Outstanding by Portfolio Segment and Class of Financing Receivable
Foreign (1)
Real estate 1-4 familyjunior lien mortgage
We employ various credit risk management and monitoring activities to mitigate risks associated with multiple risk factors affecting loans we hold or could acquire or originate including:
Loan concentrations and related credit quality
Counterparty credit risk
Economic and market conditions
Legislative or regulatory mandates
Changes in interest rates
Merger and acquisition activities
Reputation risk
Our credit risk management process is governed centrally, but provides for decentralized management and accountability by our lines of business. Our overall credit process includes comprehensive credit policies, disciplined credit underwriting, frequent and detailed risk measurement and modeling, extensive credit training programs, and a continual loan review and audit process. The Credit Committee of our Board of Directors (Board) receives reports from management, including our Chief Risk Officer and Chief Credit Officer, and its responsibilities include oversight of the administration and
effectiveness of, and compliance with, our credit policies and the adequacy of the allowance for credit losses.
A key to our credit risk management is adhering to a well controlled underwriting process, which we believe is appropriate for the needs of our customers as well as investors who purchase the loans or securities collateralized by the loans.
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Non-Strategic and Liquidating Portfolios We continually evaluate and modify our credit policies to address appropriate levels of risk. Accordingly, from time to time, we designate certain portfolios and loan products as non-strategic or liquidating to cease their continued origination as we actively work to limit losses and reduce our exposures.
Table 11 identifies our non-strategic and liquidating loan portfolios. They consist primarily of the Pick-a-Pay mortgage portfolio and other PCI loans acquired from Wachovia as well
as some portfolios from legacy Wells Fargo Home Equity and Wells Fargo Financial. Effective first quarter 2011, we added our education finance government guaranteed loan portfolio to the non-strategic and liquidating portfolios as there is no longer a U.S. Government guaranteed student loan program available to private financial institutions pursuant to legislation in 2010. The non-strategic and liquidating loan portfolios have decreased 39% since the merger with Wachovia at December 31, 2008, and decreased 13% from the end of 2010.
Table 11: Non-Strategic and Liquidating Loan Portfolios
Legacy Wachovia commercial and industrial, CRE and foreign PCI loans (1)
Pick-a-Pay mortgage (1)
Liquidating home equity
Legacy Wells Fargo Financial indirect auto
Legacy Wells Fargo Financial debt consolidation
Education Finance - government guaranteed (2)
Legacy Wachovia other PCI loans (1)
Total non-strategic and liquidating loan portfolios
The Wells Fargo Financial debt consolidation portfolio included $1.1 billion of loans at September 30, 2011, that were considered prime based on secondary market standards, compared with $1.2 billion at December 31, 2010. The remainder is non-prime but was originated with standards to reduce credit risk. Wells Fargo Financial ceased originating loans and leases through its indirect auto business channel by the end of 2008.
The home equity liquidating portfolio was designated in fourth quarter 2007 from loans generated through third party channels. This portfolio is discussed in more detail below in the “Credit Risk Management – Home Equity Portfolios” section of this Report.
Information about the liquidating PCI and Pick-a-Pay loan portfolios is provided in the discussion of loan portfolios that follows.
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Risk Management – Credit Risk Management (continued)
PURCHASED CREDIT-IMPAIRED (PCI) LOANS Loans acquired with evidence of credit deterioration since their origination and where it is probable that we will not collect all contractually required principal and interest payments are accounted for using the measurement provisions for PCI loans. PCI loans are recorded at fair value at the date of acquisition, and the historical allowance for credit losses related to these loans is not carried over. Such loans are considered to be accruing due to the existence of the accretable yield and not based on consideration given to contractual interest payments. Substantially all of our PCI loans were acquired in the Wachovia acquisition on December 31, 2008.
A nonaccretable difference is established for PCI loans to absorb losses expected on those loans at the date of acquisition. Amounts absorbed by the nonaccretable difference do not affect the income statement or the allowance for credit losses.
Substantially all commercial and industrial, CRE and foreign PCI loans are accounted for as individual loans. Conversely, Pick-a-Pay and other consumer PCI loans have been aggregated into several pools based on common risk characteristics. Each pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows.
Resolutions of loans may include sales to third parties, receipt of payments in settlement with the borrower, or foreclosure of the collateral. Our policy is to remove an individual PCI loan from a pool based on comparing the amount received from its resolution with its contractual amount. Any difference between these amounts is absorbed by the nonaccretable difference. This removal method assumes that the amount received from resolution approximates pool performance expectations. The accretable yield percentage is unaffected by the resolution and any changes in the effective yield for the remaining loans in the pool are addressed by our quarterly cash flow evaluation process for each pool. For loans that are resolved by payment in full, there is no release of the nonaccretable difference for the pool because there is no difference between the amount received at resolution and the contractual amount of the loan. Modified PCI loans are not removed from a pool even if those loans would otherwise be deemed troubled debt restructurings (TDRs). Modified PCI loans that are accounted for individually are TDRs, and removed from PCI accounting, if there has been a concession granted in excess of the original nonaccretable difference. We include these TDRs in our impaired loans.
In the first nine months of 2011, we recognized in income $184 million released from nonaccretable difference related to commercial PCI loans due to payoffs and other resolutions. We also transferred $318 million from the nonaccretable difference to the accretable yield for PCI loans with improving credit-related cash flows and absorbed $1.6 billion of losses from loan resolutions and write-downs with the nonaccretable difference. Table 12 provides an analysis of changes in the nonaccretable difference.
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Table 12: Changes in Nonaccretable Difference for PCI Loans
Balance at December 31, 2008
Release of nonaccretable difference due to:
Loans resolved by settlement with borrower (1)
Loans resolved by sales to third parties (2)
Reclassification to accretable yield for loans with improving credit-related cash flows (3)
Use of nonaccretable difference due to:
Losses from loan resolutions and write-downs (4)
Balance at December 31, 2009
Balance at December 31, 2010
Balance at September 30, 2011
Balance at June 30, 2011
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Since December 31, 2008, we have released $5.8 billion of nonaccretable difference, including $4.1 billion transferred from the nonaccretable difference to the accretable yield and $1.7 billion released to income through loan resolutions. We have provided $1.8 billion in the allowance for credit losses for PCI loans or pools of PCI loans that have had credit-related decreases to cash flows expected to be collected. The net result is a $4.0 billion reduction from December 31, 2008, through September 30, 2011, in our initial expected losses on all PCI loans.
At September 30, 2011, the allowance for credit losses on certain PCI loans was $302 million. The allowance is necessary to absorb credit-related decreases since acquisition in cash flows expected to be collected and primarily relates to individual PCI loans. Table 13 analyzes the actual and projected loss results on PCI loans since acquisition through September 30, 2011.
Table 13: Actual and Projected Loss Results on PCI Loans
Total releases of nonaccretable difference due to better than expected losses
Provision for losses due to credit deterioration (4)
Actual and projected losses on PCI loans less than originally expected
For further detail on PCI loans, see Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
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Significant Credit Concentrations and Portfolio Reviews Measuring and monitoring our credit risk is an ongoing process that tracks delinquencies, collateral values, FICO scores, economic trends by geographic areas, loan-level risk grading for certain portfolios (typically commercial) and other indications of credit risk. Our credit risk monitoring process is designed to enable early identification of developing risk and to support our determination of an adequate allowance for credit losses. The following analysis reviews the relevant concentrations and certain credit metrics of our significant portfolios. See Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for more analysis and credit metric information.
COMMERCIAL REAL ESTATE (CRE) The CRE portfolio consists of both CRE mortgage loans and CRE construction loans. The combined CRE loans outstanding at September 30, 2011, was $124.1 billion, or 16% of total loans. CRE construction loans totaled $19.7 billion at September 30, 2011, and CRE mortgage loans totaled $104.4 billion, of which 35% was to owner-occupants. Table 14 summarizes CRE loans by state and property type with the related nonaccrual totals. CRE nonaccrual loans totaled 5% of the non-PCI CRE outstanding balance at September 30, 2011, a decline of 7% from the prior quarter. The portfolio is diversified both geographically and by property type. The largest geographic concentrations of combined CRE loans are in California and Florida, which represented 25% and 10% of the total CRE portfolio, respectively. By property type, the largest concentrations are office buildings at 25% and industrial/warehouse at 11% of the portfolio. The quarter ended with $22.4 billion of criticized non-PCI CRE mortgage loans, a decrease of 14% from December 31, 2010, and $7.6 billion of criticized non-PCI construction loans, a decrease of 32% from December 31, 2010. Total criticized non-PCI CRE loans remained relatively high as a result of the continued challenging conditions in the real estate market. See Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for further detail on criticized loans.
The underwriting of CRE loans primarily focuses on cash flows inherent in the creditworthiness of the customer, in addition to collateral valuations. To identify and manage newly emerging problem CRE loans, we employ a high level of monitoring and regular customer interaction to understand and manage the risks associated with these loans, including regular loan reviews and appraisal updates. Management is engaged to identify issues and dedicated workout groups are in place to manage problem loans. At September 30, 2011, the recorded investment in PCI CRE loans totaled $4.7 billion, down from $12.3 billion at December 31, 2008, reflecting the reduction resulting from loan resolutions and write-downs.
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Table 14: CRE Loans by State and Property Type
By state:
PCI loans (1):
California
Florida
New York
Virginia
North Carolina
Total PCI loans
All other loans:
Texas
Arizona
Georgia
Colorado
Washington
Total all other loans
By property:
Apartments
Office buildings
1-4 family land
Land (excluding 1-4 family)
Retail (excluding shopping center)
Industrial/warehouse
Shopping center
Real estate-other
Hotel/motel
Institutional
Agriculture
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COMMERCIAL AND INDUSTRIAL LOANS AND LEASE FINANCING For purposes of portfolio risk management, we aggregate commercial and industrial loans and lease financing according to market segmentation and standard industry codes. Table 15 summarizes commercial and industrial loans and lease financing by industry with the related nonaccrual totals. Across our non-PCI commercial loans and leases, the commercial and industrial loans and lease financing portfolio generally experienced better credit improvement than our CRE portfolios in third quarter 2011. Of the total commercial and industrial loans and lease financing non-PCI portfolio, 0.06% was 90 days or more past due and still accruing, 1.24% was nonaccruing and 13.3% was criticized. In comparison, of the total non-PCI CRE portfolio, 0.22% was 90 days or more past due and still accruing, 5.31% was nonaccruing and 25.1% was criticized. Also, the annualized net-charge off rate for both portfolios declined from third quarter 2010. We believe the commercial and industrial loans and lease financing portfolio is well underwritten and is diverse in its risk with relatively even concentrations across several industries. Our credit risk management process for this portfolio primarily focuses on a customer’s ability to repay the loan through their cash flow.
A majority of our commercial and industrial loans and lease financing portfolio is secured by short-term liquid assets, such as accounts receivable, inventory and securities, as well as long-lived assets, such as equipment and other business assets. Generally, the collateral securing this portfolio represents a secondary source of repayment. See Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for more analysis and credit metric information.
Table 15: Commercial and Industrial Loans and Lease Financing by Industry
Technology
Healthcare
Aerospace and defense
Residential construction
Investors
Media
Financial institutions
Cyclical retailers
Food and beverage
Oil and gas
Industrial equipment
Real estate
Transportation
Business services
Public administration
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During the current credit cycle, we have experienced an increase in loans requiring risk mitigation activities including the restructuring of loan terms and requests for extensions of commercial and industrial and CRE loans. All actions are based on a re-underwriting of the loan and our assessment of the borrower’s ability to perform under the agreed-upon terms. For loans that are granted an extension, borrowers are generally performing in accordance with the contractual loan terms. Extension terms generally range from six to thirty-six months and may require that the borrower provide additional economic support in the form of partial repayment, or additional collateral or guarantees. In cases where the value of collateral or financial condition of the borrower is insufficient to repay our loan, we may rely upon the support of an outside repayment guarantee in providing the extension.
Our ability to seek performance under a guarantee is directly related to the guarantor’s creditworthiness, capacity and willingness to perform, which is evaluated on an annual basis, or more frequently as warranted. Our evaluation is based on the most current financial information available and is focused on various key financial metrics, including net worth, leverage, and current and future liquidity. We consider the guarantor’s reputation, creditworthiness, and willingness to work with us based on our analysis as well as other lenders’ experience with the guarantor. Our assessment of the guarantor’s credit strength is reflected in our loan risk ratings for such loans. The loan risk rating and accruing status are important factors in our allowance methodology for commercial and industrial and CRE loans.
In considering the accrual status of the loan, we evaluate the collateral and future cash flows as well as the anticipated support of any repayment guarantor. In many cases the strength of the guarantor provides sufficient assurance that full repayment of the loan is expected. When full and timely collection of the loan becomes uncertain, including the performance of the guarantor, we place the loan on nonaccrual status and we charge-off all or a portion of the loan based on the fair value of the collateral securing the loan, if any.
At the time of restructuring, we evaluate if the loan should be classified as a TDR, and account for it accordingly. For more information on TDRs, see “Troubled Debt Restructurings” later in this section and Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
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FOREIGN LOANS At September 30, 2011, foreign loans represented approximately 5% of our total consolidated loans outstanding and approximately 3% of our total assets. The only individual foreign country with cross-border outstandings, defined to include loans, acceptances, interest-bearing deposits with other banks, other interest bearing investments and any other monetary assets, that exceeded 0.75% of our consolidated assets at September 30, 2011, was the United Kingdom. The United Kingdom cross-border outstandings amounted to approximately $12.8 billion, or 0.98% of our consolidated assets, and included $2.2 billion of sovereign claims.
At September 30, 2011, our gross outside exposure to Greece, Ireland, Italy, Portugal and Spain, including cross-border claims on an ultimate risk basis, and foreign exchange and derivative products, aggregated approximately $3.1 billion, and we held no sovereign claims against these countries. On the same basis, our exposure to the Eurozone (the seventeen European Union member states that have adopted the euro as their common currency and sole legal tender) was $14.0 billion, including $256 million in sovereign claims against Eurozone countries. At September 30, 2011, we did not have any sovereign credit default swaps that we have written or received associated with Greece, Ireland, Italy, Portugal and Spain, nor did we have any sovereign credit default swaps written or received associated with the Eurozone.
Our foreign country risk monitoring process incorporates frequent dialogue with our foreign financial institution customers, counterparties and regulatory agencies, enhanced by centralized monitoring of macroeconomic and capital markets conditions. We establish exposure limits for each country via a centralized oversight process based on the needs of our customers, and in consideration of relevant economic, political, social, legal, and transfer risks. We monitor exposures closely and adjust our limits in response to changing conditions.
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REAL ESTATE 1-4 FAMILY MORTGAGE LOANS Our real estate 1-4 family mortgage loans primarily include loans we have made to customers and retained as part of our asset liability management strategy. These loans also include the Pick-a-Pay Portfolio acquired from Wachovia and the Home Equity Portfolio, which are discussed below. In addition, these loans include other purchased loans and loans included on our balance sheet due to the adoption of consolidation accounting guidance related to VIEs.
Our underwriting and periodic review of loans collateralized by residential real property includes appraisals or estimates from automated valuation models (AVMs) to support property values. AVMs are computer-based tools used to estimate the market value of homes. AVMs are a lower-cost alternative to appraisals and support valuations of large numbers of properties in a short period of time using market comparables and price trends for local market areas. The primary risk associated with the use of AVMs is that the value of an individual property may vary significantly from the average for the market area. We have processes to periodically validate AVMs and specific risk management guidelines addressing the circumstances when AVMs may be used. AVMs are generally used in underwriting to support property values on loan originations only where the loan amount is under $250,000. We generally require property visitation appraisals by a qualified independent appraiser for larger residential property loans.
Some of our real estate 1-4 family first and junior lien mortgage loans include an interest-only feature as part of the loan terms. These interest-only loans were approximately 22% of total loans at September 30, 2011 and 25% at December 31, 2010. Substantially all of these interest-only loans at origination were considered to be prime or near prime.
We believe we have manageable adjustable-rate mortgage (ARM) reset risk across our owned mortgage loan portfolios. We do not offer option ARM products, nor do we offer variable-rate mortgage products with fixed payment amounts, commonly referred to within the financial services industry as negative amortizing mortgage loans. Our liquidating option ARM portfolio was acquired from Wachovia.
We continue to modify real estate 1-4 family mortgage loans to assist homeowners and other borrowers in the current difficult economic cycle. Loans are underwritten at the time of the modification in accordance with underwriting guidelines established for governmental and proprietary loan modification programs. As a participant in the U.S. Treasury’s Making Home Affordable (MHA) programs, we are focused on helping customers stay in their homes. The MHA programs create a standardization of modification terms including incentives paid to borrowers, servicers, and investors. MHA includes the Home Affordable Modification Program (HAMP) for first lien loans and the Second Lien Modification Program (2MP) for junior lien loans. Under both our proprietary programs and the MHA programs, we may provide concessions such as interest rate reductions, forbearance of principal, and in some cases, principal forgiveness. These programs generally include trial payment periods of three to four months, and after successful completion and compliance with terms during this period, the loan is modified and accounted for as a troubled debt restructured loan. See Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for discussion on how we determine the allowance attributable to our modified residential real estate portfolios.
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The concentrations of real estate 1-4 family first and junior lien mortgage loans by state are presented in Table 16. Our real estate 1-4 family mortgage loans to borrowers in California represented approximately 13% of total loans (3% of this amount were PCI loans from Wachovia) at September 30, 2011, mostly within the larger metropolitan areas, with no single California metropolitan area consisting of more than 3% of total loans. We continuously monitor changes in real estate values and underlying economic or market conditions for all geographic areas of our real estate 1-4 family mortgage portfolio as part of our credit risk management process.
Part of our credit monitoring includes tracking delinquency, FICO scores and collateral values (LTV/CLTV) on the entire real estate 1-4 family mortgage loan portfolio. The delinquency metric has held stable and the other two risk metrics have shown improvement during 2011, on the non-PCI mortgage portfolio. Loans 30 days or more delinquent at September 30, 2011, totaled $18.5 billion, or 7%, of total non-PCI mortgages, down 9% from December 31, 2010. Loans with FICO scores lower than 640 totaled $44.7 billion at September 30, 2011 or 16% of all non-PCI mortgages, a decline of 12% from year-end 2010. Mortgages with a LTV/CLTV greater than 100% totaled $74.0 billion at September 30, 2011 or 26% of total non-PCI mortgages, a 13% decline from year-end 2010. Information regarding credit risk trends can be found in Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
Table 16: Real Estate 1-4 Family Mortgage Loans by State
PCI loans:
New Jersey
Other (1)
Pennsylvania
Other (2)
Total allother loans
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PICK-A-PAY PORTFOLIO The Pick-a-Pay portfolio was one of the consumer residential first mortgage portfolios we acquired from Wachovia and a majority of the portfolio was identified as PCI loans. The Pick-a-Pay portfolio is a liquidating portfolio, as Wachovia ceased originating new Pick-a-Pay loans in 2008.
The Pick-a-Pay portfolio includes loans that offer payment options (Pick-a-Pay option payment loans), and also includes loans that were originated without the option payment feature, loans that no longer offer the option feature as a result of our modification efforts since the acquisition, and loans where the
customer voluntarily converted to a fixed-rate product. The Pick-a-Pay portfolio is included in the consumer real estate 1-4 family first mortgage class of loans throughout this Report. Real estate 1-4 family junior lien mortgages and lines of credit associated with Pick-a-Pay loans are reported in the Home Equity portfolio. Table 17 provides balances over time related to the types of loans included in the portfolio since acquisition.
Table 17: Pick-a-Pay Portfolio - Balances Over Time
Option payment loans
Non-option payment adjustable-rate and fixed-rate loans
Full-term loan modifications
Total adjusted unpaid principal balance
Total carrying value
PCI loans in the Pick-a-Pay portfolio had an adjusted unpaid principal balance of $38.1 billion and a carrying value of $29.7 billion at September 30, 2011. The carrying value of the PCI loans is net of remaining purchase accounting write-downs, which reflected their fair value at acquisition. At acquisition, we recorded a $22.4 billion write-down in purchase accounting on Pick-a-Pay loans that were impaired.
Pick-a-Pay option payment loans may be adjustable or fixed rate. They are home mortgages on which the customer has the option each month to select from among four payment options: (1) a minimum payment as described below, (2) an interest-only payment, (3) a fully amortizing 15-year payment, or (4) a fully amortizing 30-year payment.
The minimum monthly payment for substantially all of our Pick-a-Pay loans is reset annually. The new minimum monthly payment amount usually cannot increase by more than 7.5% of the then-existing principal and interest payment amount. The minimum payment may not be sufficient to pay the monthly interest due and in those situations a loan on which the customer has made a minimum payment is subject to “negative amortization,” where unpaid interest is added to the principal balance of the loan. The amount of interest that has been added to a loan balance is referred to as “deferred interest.” Total deferred interest of $2.1 billion at September 30, 2011, down from $2.7 billion at December 31, 2010, was due to loan modification efforts as well as falling interest rates resulting in the minimum payment option covering interest and some principal on many loans. Approximately 82% of the Pick-a-Pay customers making a minimum payment in September 2011 did not defer interest.
Deferral of interest on a Pick-a-Pay loan may continue as long as the loan balance remains below a pre-defined principal cap, which is based on the percentage that the current loan balance represents to the original loan balance. Loans with an original loan-to-value (LTV) ratio equal to or below 85% have a cap of 125% of the original loan balance, and these loans represent substantially all the Pick-a-Pay portfolio. Loans with an original LTV ratio above 85% have a cap of 110% of the original loan balance. Most of the Pick-a-Pay loans on which there is a deferred interest balance re-amortize (the monthly payment amount is reset or “recast”) on the earlier of the date when the loan balance reaches its principal cap, or the 10-year anniversary of the loan. For a small population of Pick-a-Pay loans, the recast occurs at the five-year anniversary. After a recast, the customers’ new payment terms are reset to the amount necessary to repay the balance over the remainder of the original loan term.
Due to the terms of the Pick-a-Pay portfolio, there is little recast risk in the near term. Based on assumptions of a flat rate environment, if all eligible customers elect the minimum payment option 100% of the time and no balances prepay, we would expect the following balances of loans to recast based on reaching the principal cap: $2 million for the remainder of 2011, $3 million in 2012, and $24 million in 2013. In third quarter 2011, $0.4 million was recast based on reaching the principal cap. In addition, in a flat rate environment, we would expect the following balances of loans to start fully amortizing due to reaching their recast anniversary date and also having a payment change at the recast date greater than the annual 7.5% reset: $2 million for the remainder of 2011, $61 million in 2012, and
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$255 million in 2013. In third quarter 2011, the amount of loans reaching their recast anniversary date and also having a payment change over the annual 7.5% reset was $5 million.
Table 18 reflects the geographic distribution of the Pick-a-Pay portfolio broken out between PCI loans and all other loans. In stressed housing markets with declining home prices and increasing delinquencies, the LTV ratio is a useful metric in predicting future real estate 1-4 family first mortgage loan
performance, including potential charge-offs. Because PCI loans were initially recorded at fair value, including write-downs for expected credit losses, the ratio of the carrying value to the current collateral value will be lower compared with the LTV based on the adjusted unpaid principal balance. For informational purposes, we have included both ratios for PCI loans in the following table.
Table 18: Pick-a-Pay Portfolio (1)
Other states
Total Pick-a-Pay loans
To maximize return and allow flexibility for customers to avoid foreclosure, we have in place several loss mitigation strategies for our Pick-a-Pay loan portfolio. We contact customers who are experiencing difficulty and may in certain cases modify the terms of a loan based on a customer’s documented income and other circumstances.
We also have taken steps to work with customers to refinance or restructure their Pick-a-Pay loans into other loan products. For customers at risk, we offer combinations of term extensions of up to 40 years (from 30 years), interest rate reductions, forbearance of principal, and, in geographies with substantial property value declines, we may offer permanent principal reductions.
In third quarter 2011, we completed more than 5,000 proprietary and HAMP Pick-a-Pay loan modifications and have completed more than 96,000 modifications since the Wachovia acquisition, resulting in $4.0 billion of principal forgiveness to our Pick-a-Pay customers. As announced in October 2010, we entered into agreements with certain state attorneys general whereby we agreed to offer loan modifications to eligible Pick-a-Pay customers through June 2013. These agreements cover the majority of our option payment loan portfolio and require that we offer modifications (both HAMP and proprietary) to eligible customers with the option payment loan product. In response to
these agreements, we developed an enhanced proprietary modification product that allows for various means of principal forgiveness along with changes to other loan terms. Given that these agreements cover all modification efforts to eligible customers for the applicable states, a majority of our modifications (both HAMP and proprietary) for our Pick-a-Pay loan portfolio performed in third quarter 2011 were consistent with these agreements.
Due to better than expected performance observed on the Pick-a-Pay portfolio compared with the original acquisition estimates, we have reclassified $2.4 billion from the nonaccretable difference to the accretable yield since acquisition. This performance is primarily attributable to significant modification efforts as well as the portfolio’s delinquency stabilization. The resulting increase in the accretable yield will be realized over the remaining life of the portfolio, which is estimated to have a weighted-average life of approximately 11 years. The accretable yield percentage in third quarter 2011 was 4.11%, down from 4.54% in fourth quarter 2010. Fluctuations in the accretable yield are driven by changes in interest rate indices for variable rate PCI loans, prepayment assumptions, and expected principal and interest payments over the estimated life of the portfolio, which will be impacted by the pace and degree of improvements in the U.S. economy and housing markets and
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projected lifetime performance resulting from loan modification activity. Changes in the projected timing of cash flow events, including loan liquidations, modifications and short sales, can
also affect the accretable yield percentage and the estimated weighted-average life of the portfolio.
HOME EQUITY PORTFOLIOS Our Home Equity Portfolios consist of real estate 1-4 family junior lien mortgages and first and junior lines of credit secured by real estate. Our first lien lines of credit represent 19% of our home equity portfolio and are included in real estate 1-4 family first mortgages. The majority of our junior lien loan products are amortizing payment loans with fixed interest rates and repayment periods between 5 to 30 years. Junior lien loans with balloon payments at the end of the repayment term represent a small portion of our junior lien loans.
Our first and junior lien lines of credit products generally have a draw period of 10 years with variable interest rates and payment options during the draw period of (1) interest only or (2) 1.5% of total outstanding balance. During the draw period, the borrower has the option of converting all or a portion of the line from a variable interest rate to a fixed rate with terms including interest-only payments for a fixed period between three to seven years or a fully amortizing payment with a fixed period between five to 30 years. At the end of the draw period, a line of credit generally converts to an amortizing payment loan with repayment terms of up to 30 years based on the balance at time of conversion. The draw periods for a majority of our lines of credit end after 2015.
We continuously monitor the credit performance of our junior lien mortgage portfolio for trends and factors that influence the frequency and severity of loss. We have observed that the severity of loss for junior lien mortgages is high and generally not affected by whether we or a third party own or service the related first mortgage, but that the frequency of loss is lower when we own or service the first mortgage. In general, we have limited information available on the delinquency status of the third party owned or serviced senior lien where we also have a junior lien. To capture this inherent loss content, we use the experience of our junior lien mortgages behind delinquent first liens that are owned or serviced by us adjusted for observed higher delinquency rates associated with junior lien mortgages behind third party first mortgages. We incorporate this inherent loss content into our allowance for loan losses. During second quarter 2011, we refined our allowance process related to this loss content, which added $210 million to our allowance. We did not make any refinements to the allowance process for these loans in third quarter 2011. Table 19 summarizes delinquency and loss rates by the holder of the lien.
Table 19: Home Equity Portfolios Performance by Holder of 1st Lien (1)
First lien lines
Junior lien behind:
Wells Fargo owned or serviced first lien
Third party first lien
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We also monitor the number of borrowers paying the minimum amount due on a monthly basis. In September 2011, approximately 93% of our borrowers with home equity line outstanding balances paid at least the minimum amount due, which included 47% of our borrowers paying only the minimum amount due.
The home equity liquidating portfolio includes home equity loans generated through third party channels, including correspondent loans. This liquidating portfolio represents less than 1% of our total loans outstanding at September 30, 2011, and contains some of the highest risk in our home equity portfolio, with a loss rate of 8.97% compared with 2.88% for the core (non-liquidating) home equity portfolio. Table 20 shows the credit attributes of the core and liquidating home
equity portfolios and lists the top five states. California loans represent the largest state concentration in each of these portfolios. The decrease in outstanding balances primarily reflects loan paydowns and charge-offs. As of September 30, 2011, 35% of the outstanding balance of the core home equity portfolio was associated with loans that had a combined loan to value (CLTV) ratio in excess of 100%. CLTV means the ratio of the total unpaid principal balance of first mortgages and junior lien mortgages (including unused line amounts for credit line products) to property collateral value. The unsecured portion of the outstanding balances of these loans (the outstanding amount that was in excess of the most recent property collateral value) totaled 17% of the core home equity portfolio at September 30, 2011.
Table 20: Home Equity Portfolios (1)
Core portfolio (2)
Liquidating portfolio
Minnesota
Total core and liquidating portfolios
CREDIT CARDS Our credit card portfolio totaled $21.7 billion at September 30, 2011, which represented 3% of our total outstanding loans. The quarterly net charge-off rate (annualized) for our credit card loans declined for the last six consecutive quarters and was 4.90% for third quarter 2011 compared with 9.06% for third quarter 2010.
OTHER REVOLVING CREDIT AND INSTALLMENT Other revolving credit and installment loans totaled $86.6 billion at September 30, 2011, and predominantly include automobile, student and security-based margin loans. The quarterly loss rate (annualized) for other revolving credit and installment loans was 1.19% for third quarter 2011 compared with 1.84% for third quarter 2010. Excluding government guaranteed student loans, the loss rates were 1.42% and 2.29% for third quarter 2011 and 2010, respectively.
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NONACCRUAL LOANS AND FORECLOSED ASSETS We generally place loans on nonaccrual status when:
the full and timely collection of interest or principal becomes uncertain (generally based on an assessment of the borrower’s financial condition and the adequacy of collateral, if any);
they are 90 days (120 days with respect to real estate 1-4 family first and junior lien mortgages) past due for interest or principal, unless both well-secured and in the process of collection; or
part of the principal balance has been charged off and no restructuring has occurred.
Table 21 shows a declining quarterly trend for total nonaccrual loans.
Table 21: Nonperforming Assets (Nonaccrual Loans and Foreclosed Assets)
Total commercial (1)
Real estate 1-4 family first mortgage (2)
Total nonaccrual loans (3)(4)(5)
Foreclosed assets:
Government insured/guaranteed (6)
Non-government
insured/guaranteed
Total foreclosed assets
Total nonperforming assets
Reduction in NPAs from prior quarter
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Total NPAs were $26.8 billion (3.53% of total loans) at September 30, 2011, and included $21.9 billion of nonaccrual loans and $4.9 billion of foreclosed assets. Since the peak in
third quarter 2010, NPAs have declined for all loan and other asset types through September 30, 2011. Table 22 provides an analysis of the changes in nonaccrual loans.
Table 22: Analysis of Changes in Nonaccrual Loans
Commercial nonaccrual loans
Balance, beginning of quarter
Inflows
Outflows
Balance, end of quarter
Consumer nonaccrual loans
Total nonaccrual loans
Typically, changes to nonaccrual loans period-over-period represent inflows for loans that reach a specified past due status, offset by reductions for loans that are charged off, sold, transferred to foreclosed properties, or are no longer classified as nonaccrual as a result of continued performance and an improvement in the borrower’s financial strength and loan repayment capabilities.
While nonaccrual loans are not free of loss content, we believe exposure to loss is significantly mitigated by four factors. First, 99% of consumer nonaccrual loans and 96% of commercial nonaccrual loans are secured. Of the $13.3 billion of consumer nonaccrual loans at September 30, 2011, 98% are secured by real estate and 35% have a combined LTV (CLTV) ratio of 80% or below. Second, losses have already been recognized on 50% of the remaining balance of consumer nonaccruals and commercial nonaccruals have been written down by $2.1 billion. Generally, when a consumer real estate loan is 120 days past due, we transfer it to nonaccrual status. When the loan reaches 180 days past due it is our policy to write these loans down to net realizable value (fair value of collateral less estimated costs to sell), except for modifications in their trial period that are not written down as long as trial payments are made on time. Thereafter, we revalue each loan regularly and recognize additional write-downs if needed. Third, as of September 30, 2011, 57% of commercial nonaccrual loans were current on interest. Fourth, the risk of loss for all nonaccruals has been considered and we believe is adequately covered by the allowance for loan losses.
Under both our proprietary modification programs and the MHA programs, customers may be required to provide updated documentation, and some programs require completion of trial payment periods to demonstrate sustained performance, before the loan can be removed from nonaccrual status. In addition, for loans in foreclosure, many states, including California, Florida and New Jersey, have enacted legislation that significantly increases the time frames to complete the foreclosure process, meaning that loans will remain in nonaccrual status for longer periods. At the
conclusion of the foreclosure process, we continue to sell real estate owned in a timely manner.
Table 23 provides a summary of foreclosed assets and an analysis of the changes.
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Balance, period end
Government insured/guaranteed (1)
Analysis of changes in foreclosed assets
Net change in government insured/guaranteed (2)
Foreclosed assets acquired
Reductions:
Sales
Write-downs and loss on sales
Total reductions
NPAs at September 30, 2011, included $1.3 billion of foreclosed real estate that is FHA insured or VA guaranteed and expected to have little to no loss content, and $3.6 billion of foreclosed assets, which have been written down to net realizable value. Foreclosed assets decreased $1.2 billion, or 19%, year over year in third quarter 2011. Of this decrease, $543 million were foreclosed loans from the PCI portfolio that are now recorded as foreclosed assets. At September 30, 2011, most of our foreclosed assets of $4.9 billion have been in the foreclosed assets portfolio one year or less. Given our real estate-secured loan concentrations and current economic conditions, we anticipate we will continue to hold a high level of NPAs on our balance sheet.
The performance of any one loan can be affected by external factors, such as economic or market conditions, or factors affecting a particular borrower. See the “Risk Management – Allowance for Credit Losses” section in this Report for additional information.
We process foreclosures on a regular basis for the loans we service for others as well as those we hold in our loan portfolio. We use foreclosure, however, only as a last resort for dealing with borrowers experiencing financial hardships. We employ extensive contact and restructuring procedures to attempt to find other solutions for our borrowers. We maintain appropriate staffing in our workout and collection teams to ensure troubled borrowers receive appropriate attention and assistance.
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TROUBLED DEBT RESTRUCTURINGS (TDRs)
Commercial TDRs
Leasing
Total commercial TDRs
Consumer TDRs:
Total consumer TDRs
Total TDRs
TDRs on nonaccrual status
TDRs on accrual status
Table 24 provides information regarding the recorded investment of loans modified in TDRs. The amounts previously reported for the quarters ended June 30 and March 31, 2011 have been revised to reflect the retrospective adoption from the beginning of 2011 of ASU 2011-2, which clarified guidance for classifying modifications as TDRs. This new guidance specifically clarifies, among other things, the definition of a concession, including how to evaluate modified loan terms against terms that would be commensurate for loans with similar credit risk. For our commercial loan modifications, we do not typically modify principal through forgiveness or forbearance or reduce the contractual interest rate. In fact, in many cases, we obtain higher rates of interest, additional collateral or guarantor support, or other improvements to the terms. Certain commercial loan modifications are now classified as TDRs under the clarified guidance. See Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report for more information.
We do not forgive principal for a majority of our TDRs, but in those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. We sometimes delay the timing on the repayment of a portion of principal (principal forbearance) and charge off the amount of forbearance if that amount is not considered fully collectible.
Our nonaccrual policies are generally the same for all loan types when a restructuring is involved. We underwrite loans at the time of restructuring to determine whether there is sufficient evidence of sustained repayment capacity based on the borrower’s documented income, debt to income ratios, and other factors. Any loans lacking sufficient evidence of sustained repayment capacity at the time of modification are charged down
to the fair value of the collateral, if applicable. For an accruing loan that has been modified, if the borrower has demonstrated performance under the previous terms and the underwriting process shows the capacity to continue to perform under the restructured terms, the loan will remain in accruing status. Otherwise, the loan will be placed in nonaccrual status until the borrower demonstrates a sustained period of performance, generally six consecutive months of payments, or equivalent, inclusive of consecutive payments made prior to modification. Loans will also be placed on nonaccrual, and a corresponding charge-off is recorded to the loan balance, if we believe that principal and interest contractually due under the modified agreement will not be collectible.
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Table 25 provides an analysis of the changes in TDRs.
Table 25: Analysis of Changes in TDRs
Consumer TDRs
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LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING Loans 90 days or more past due as to interest or principal are still accruing if they are (1) well-secured and in the process of collection or (2) real estate 1-4 family mortgage loans or consumer loans exempt under regulatory rules from being classified as nonaccrual until later delinquency, usually 120 days past due. PCI loans of $8.9 billion, $9.8 billion, $10.8 billion, $11.6 billion and $13.0 billion at September 30, June 30 and March 31, 2011, and December 31 and September 30, 2010, respectively, are excluded from this disclosure even though they are 90 days or more contractually past due. These PCI loans are considered to be accruing due to the existence of the accretable yield and not based on consideration given to contractual interest payments.
Excluding insured/guaranteed loans, loans 90 days or more past due and still accruing at September 30, 2011, were down $720 million, or 27%, from December 31, 2010. The decline was due to loss mitigation activities including modifications and increased collection capacity/process improvements, charge-offs, stable early stage delinquency levels and credit stabilization.
Table 26 reflects non-PCI loans 90 days or more past due and still accruing by class for loans not government insured/guaranteed. For additional information on delinquencies by loan class, see Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
Total (excluding PCI):
Less: FHA insured/guaranteed by the VA (1)
Less: Student loans guaranteed under the FFELP (2)
Total, not government insured/guaranteed
By segment and class, not government insured/guaranteed:
Real estate 1-4 family first mortgage (3)
Real estate 1-4 family junior lien mortgage (3)
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NET CHARGE-OFFS
Table 27 presents net charge-offs for third quarter 2011 and the previous four quarters. Net charge-offs in third quarter 2011 were $2.6 billion (1.37% of average total loans outstanding) compared with $4.1 billion (2.14%) in third quarter 2010.
Net charge-offs in the 1-4 family first mortgage portfolio totaled $821 million in third quarter 2011, compared with $1.0 billion in the same quarter a year ago.
Net charge-offs in the real estate 1-4 family junior lien portfolio were $842 million in third quarter 2011. More information about the Home Equity portfolio, which includes substantially all of our real estate 1-4 family junior lien mortgage loans, is available in Table 20 in this Report and the related discussion.
Credit card net charge-offs of $266 million in third quarter 2011 decreased $238 million from a year ago.
Commercial net charge-offs were $423 million in third quarter 2011 compared with $1.1 billion a year ago. Commercial credit results continued to improve from third quarter 2010 as market liquidity and improving market conditions helped stabilize performance results.
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ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses, which consists of the allowance for loan losses and the allowance for unfunded credit commitments, is management’s estimate of credit losses inherent in the loan portfolio and unfunded credit commitments at the balance sheet date, excluding loans carried at fair value. The detail of the changes in the allowance for credit losses by portfolio segment (including charge-offs and recoveries by loan class) is in Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report. Table 28 provides a summary of our allowance for credit losses.
We employ a disciplined process and methodology to establish our allowance for credit losses each quarter. This process takes into consideration many factors, including historical and forecasted loss trends, loan-level credit quality ratings and loan grade-specific loss factors. The process involves subjective and complex judgments. In addition, we review a variety of credit metrics and trends. These trends, however, do not solely determine the amount of the allowance as we use several analytical tools in determining its adequacy. For additional information on our allowance for credit losses, see the “Critical Accounting Policies – Allowance for Credit Losses” section in our 2010 Form 10-K and Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
Components:
Allowance for unfunded credit commitments
Allowance for credit losses
Allowance for credit losses related to PCI loans
Allowance for loan losses as a percentage of total loans
Allowance for loan losses as a percentage of annualized net charge-offs
Allowance for credit losses as a percentage of total loans
Allowance for credit losses as a percentage of total nonaccrual loans
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In addition to the allowance for credit losses, there was $11.3 billion at September 30, 2011, and $12.1 billion at June 30, 2011, of nonaccretable difference to absorb losses for PCI loans. For additional information on PCI loans, see the “Risk Management – Credit Risk Management – Purchased Credit-Impaired Loans” section and Note 5 (Loans and Allowance for Credit Losses) to Financial Statements in this Report.
The ratio of the allowance for credit losses to total nonaccrual loans may fluctuate significantly from period to period due to such factors as the mix of loan types in the portfolio, borrower credit strength and the value and marketability of collateral. Over half of nonaccrual loans were home mortgages at September 30, 2011.
The $854 million linked-quarter decline in the allowance for loan losses in third quarter 2011 reflected continued improvement in consumer delinquency trends, fewer nonperforming loans and improved portfolio performance. Total provision for credit losses was $1.8 billion in third quarter 2011, compared with $3.4 billion a year ago. The third quarter 2011 provision was $800 million less than net charge-offs, compared with a provision that was $1.0 billion, $1.0 billion, $850 million and $650 million less than net charge-offs in the second and first quarters of 2011 and the fourth and third quarters of 2010, respectively.
Changes in the allowance reflect changes in statistically derived loss estimates, historical loss experience, current trends in borrower risk and/or general economic activity on portfolio performance, and management’s estimate for imprecision and uncertainty, including ongoing discussions with regulatory and government agencies regarding mortgage foreclosure-related matters.
We believe the allowance for credit losses of $20.4 billion was adequate to cover credit losses inherent in the loan portfolio, including unfunded credit commitments, at September 30, 2011. The allowance for credit losses is subject to change and considers existing factors at the time, including economic or market conditions and ongoing internal and external examination processes. Due to the sensitivity of the allowance for credit losses to changes in our external business environment, it is possible that we will have to record incremental credit losses not anticipated as of the balance sheet date. Absent significant deterioration in the economy, we expect future reserve releases. Our process for determining the allowance for credit losses is discussed in the “Critical Accounting Policies – Allowance for Credit Losses” section in our 2010 Form 10-K and Note 5 (Loans and Allowance for Credit Losses) to the Financial Statements in this Report.
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LIABILITY FOR MORTGAGE LOAN REPURCHASE LOSSES We sell residential mortgage loans to various parties, including (1) government-sponsored entities Freddie Mac and Fannie Mae (GSEs) who include the mortgage loans in GSE-guaranteed mortgage securitizations, (2) special purpose entities (SPEs) that issue private label mortgage-backed securities (MBS), and (3) other financial institutions that purchase mortgage loans for investment or private label securitization. In addition, we pool FHA-insured and VA-guaranteed mortgage loans that back securities guaranteed by GNMA. We may be required to repurchase these mortgage loans, indemnify the securitization trust, investor or insurer, or reimburse the securitization trust, investor or insurer for credit losses incurred on loans (collectively “repurchase”) in the event of a breach of contractual representations or warranties that is not remedied within a period (usually 90 days or less) after we receive notice of the breach. For additional information see our 2010 Form 10-K.
We have established a mortgage repurchase liability related to various representations and warranties that reflect management’s estimate of losses for loans for which we have a repurchase obligation, whether or not we currently service those loans, based on a combination of factors. Our mortgage repurchase liability estimation process also incorporates projected and on hand mortgage insurance rescissions that we deem to be probable to result in a repurchase demand. Currently, repurchase demands primarily relate to 2006 through 2008 vintages and to GSE-guaranteed MBS.
During third quarter 2011, we observed an increase in losses compared with second quarter 2011. We repurchased or reimbursed investors for incurred losses on mortgage loans with original balances of $788 million. We incurred net losses on repurchased loans and investor reimbursements of $384 million in third quarter 2011.
Table 29 provides the number of unresolved repurchase demands and mortgage insurance rescissions. We do not typically receive repurchase requests from GNMA, FHA/HUD or VA. As an originator of an FHA insured or VA guaranteed loan, we are responsible for obtaining the insurance with FHA or the guarantee with the VA. To the extent we are not able to obtain the insurance or the guarantee we can request to repurchase the loan from the GNMA pool. Such repurchases from GNMA pools typically represent a self-initiated process upon discovery of the uninsurable loan (usually within 180 days from funding of the loan). Alternatively, in lieu of repurchasing loans from GNMA pools, we may be asked by the FHA/HUD or the VA to indemnify loans due to defects found in the Post Endorsement Technical Review process or audits performed by FHA/HUD or the VA. Our liability for mortgage loan repurchase losses incorporates probable losses associated with indemnified loans in GNMA pools and uninsurable loans.
2011
September 30,
June 30,
March 31,
2010
December 31,
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The level of repurchase demands outstanding at September 30, 2011, was down from a year ago in both number of outstanding loans and in total dollar balances as we continued to work through the demands. Customary with industry practice, we have the right of recourse against correspondent lenders from whom we have purchased loans with respect to representations and warranties. Of the repurchase demands presented in Table 29, approximately 20% relate to loans purchased from correspondent lenders. Due primarily to the financial difficulties of some correspondent lenders, we typically recover on average approximately 50% of losses from these lenders. Historical recovery rates as well as projected lender performance are incorporated in the establishment of our mortgage repurchase liability.
Our liability for repurchases, included in “Accrued expenses and other liabilities” in our consolidated financial statements, was $1.2 billion at September 30 and June 30, 2011. In the quarter ended September 30, 2011, $390 million of additions to the liability were recorded, which reduced net gains on mortgage loan origination/sales activities. Our additions to the repurchase liability in the quarter ended September 30, 2011, were up from amounts recorded in the first two quarters of 2011 and reflect updated assumptions about probable future demands. This increase in our estimate for probable future demands was primarily due to an increase in repurchase demands on the 2006-2008 vintages from the Federal National Mortgage Association (FNMA).
We believe we have a high quality residential mortgage loan servicing portfolio. Of the $1.8 trillion in the residential mortgage loan servicing portfolio at September 30, 2011, 92% was current, less than 2% was subprime at origination, and approximately 1% was home equity securitizations. Our combined delinquency and foreclosure rate on this portfolio was 7.63% at September 30, 2011, compared with 7.44% at June 30, 2011. In this portfolio 6% are private securitizations where we originated the loan and therefore have some repurchase risk. For this private securitization segment of our residential mortgage loan servicing portfolio, 58% are loans from 2005 vintages or earlier (weighted average age of 72 months); 80% were prime at origination; and approximately 70% are jumbo loans. The weighted-average LTV as of September 30, 2011, for this private securitization segment was 80%. We believe the highest risk segment of these private securitizations is the subprime loans originated in 2006 and 2007. These subprime loans have seller representations and warranties and currently have LTVs close to or exceeding 100%, and represent 8% of the 6% private securitization portion of the residential mortgage servicing portfolio. We had only $11 million of repurchased loans related to private securitizations in third quarter 2011. Of the servicing portfolio, 4% is non-agency acquired servicing and 2% is private whole loan sales. We did not underwrite and securitize the non-agency acquired servicing and therefore we have no obligation on that portion of our servicing portfolio to the investor for any repurchase demands arising from origination practices. For the private whole loan segment, while we do have repurchase risk on these prior loan sales, less than 2% were subprime at origination and loans that were sold and subsequently securitized are included in the private securitization segment discussed above.
Table 30 summarizes the changes in our mortgage repurchase liability.
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Table 30: Changes in Mortgage Repurchase Liability
Balance, beginning of period
Provision for repurchase losses:
Loan sales
Change in estimate - primarily due to credit deterioration
Total additions
Losses
Balance, end of period
The mortgage repurchase liability of $1.2 billion at September 30, 2011, represents our best estimate of the probable loss that we will incur related to representations and warranties in the contractual provisions of our sales of mortgage loans. Because the level of mortgage loan repurchase losses depends upon economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of the liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment. We maintain regular contact with the GSEs and other significant investors to monitor and address their repurchase demand practices and concerns. Because of the uncertainty in the various estimates underlying the mortgage repurchase liability, there is a range of losses in excess of the recorded mortgage repurchase liability that are reasonably possible. The estimate of the range of possible loss for representations and warranties does not represent a probable loss, and is based on currently available information, significant judgment, and a number of assumptions that are subject to change. The high end of this range of reasonably possible losses in excess of our recorded liability was $1.9 billion at September 30, 2011, and was determined based upon modifying the assumptions utilized in our best estimate of probable loss to reflect what we believe to be the high end of reasonably possible adverse assumptions. For additional information on our repurchase liability, see the “Critical Accounting Policies – Liability for Mortgage Loan Repurchase Losses” section in our 2010 Form 10-K and Note 8 (Mortgage Banking Activities) to Financial Statements in this Report.
To the extent that economic conditions and the housing market do not improve or future investor repurchase demands and appeals success rates differ from past experience, we could continue to have increased demands and increased loss severity on repurchases, causing future additions to the repurchase liability. However, some of the underwriting standards that were permitted by the GSEs for conforming loans in the 2006 through 2008 vintages, which significantly contributed to recent levels of repurchase demands, were tightened starting in mid to late 2008. Accordingly, we do not expect a similar rate of repurchase requests from the 2009 and prospective vintages, absent deterioration in economic conditions or changes in investor behavior.
In October 2011, the Arizona Department of Insurance assumed full and exclusive power of management and control of PMI Mortgage Insurance Co. (PMI). PMI will pay 50% of claim
amounts in cash, with the rest deferred. Wells Fargo has previously utilized PMI to provide mortgage insurance on certain loans originated and held in our portfolio. Additionally, PMI has provided mortgage insurance on loans originated and sold to third party investors. For loans sold to third party investors, there is no additional risk of repurchase loss to Wells Fargo associated with the deferred insurance claim amounts from PMI since this credit risk is owned by the investor in the loan. We also hold a small amount of residential mortgage-backed securities, which are backed by mortgages with a limited amount of insurance provided by PMI. Because the loans and securities held in our portfolios with PMI insurance support are limited in amount, we do not anticipate the deferred claim payments will result in a material adverse effect on our consolidated financial statements.
RISKS RELATING TO SERVICING ACTIVITIES In addition to servicing loans in our portfolio, we act as servicer and/or master servicer of residential mortgage loans included in GSE-guaranteed mortgage securitizations, GNMA-guaranteed mortgage securitizations and private label mortgage securitizations, as well as for unsecuritized loans owned by institutional investors. The loans we service were originated by us or by other mortgage loan originators. As servicer, our primary duties are typically to (1) collect payment due from borrowers, (2) advance certain delinquent payments of principal and interest, (3) maintain and administer any hazard, title or primary mortgage insurance policies relating to the mortgage loans, (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments, and (5) foreclose on defaulted mortgage loans or, to the extent consistent with the documents governing a securitization, consider alternatives to foreclosure, such as loan modifications or short sales. As master servicer, our primary duties are typically to (1) supervise, monitor and oversee the servicing of the mortgage loans by the servicer, (2) consult with each servicer and use reasonable efforts to cause the servicer to observe its servicing obligations, (3) prepare monthly distribution statements to security holders and, if required by the securitization documents, prepare certain periodic reports required to be filed with the Securities and Exchange Commission (SEC), (4) if required by the securitization documents, calculate distributions and loss allocations on the mortgage-backed securities, (5) prepare tax and information returns of the securitization trust, and (6) advance amounts
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required by non-affiliated servicers who fail to perform their advancing obligations.
Each agreement under which we act as servicer or master servicer generally specifies a standard of responsibility for actions we take in such capacity and provides protection against expenses and liabilities we incur when acting in compliance with the specified standard. For example, most private label securitization agreements under which we act as servicer or master servicer typically provide that the servicer and the master servicer are entitled to indemnification by the securitization trust for taking action or refraining from taking action in good faith or for errors in judgment. However, we are not indemnified, but rather are required to indemnify the securitization trustee, against any failure by us, as servicer or master servicer, to perform our servicing obligations or any of our acts or omissions that involve wilful misfeasance, bad faith or gross negligence in the performance of, or reckless disregard of, our duties. In addition, if we commit a material breach of our obligations as servicer or master servicer, we may be subject to termination if the breach is not cured within a specified period following notice, which can generally be given by the securitization trustee or a specified percentage of security holders. Whole loan sale contracts under which we act as servicer generally include similar provisions with respect to our actions as servicer. The standards governing servicing in GSE-guaranteed securitizations, and the possible remedies for violations of such standards, vary, and those standards and remedies are determined by servicing guides maintained by the GSEs, contracts between the GSEs and individual servicers and topical guides published by the GSEs from time to time. Such remedies could include indemnification or repurchase of an affected mortgage loan and these losses are generally included as a reduction to net servicing income within mortgage banking noninterest income.
For additional information regarding risks relating to our servicing activities, see pages 75-76 in our 2010 Form 10-K.
The Board of Governors of the Federal Reserve System (FRB) and the Office of the Comptroller of the Currency (OCC) issued consent orders, made public April 13, 2011, that require us to correct deficiencies in our residential mortgage loan servicing and foreclosure practices that were identified by federal banking regulators in their fourth quarter 2010 review. The consent orders also require that we improve our servicing and foreclosure practices. We are committed to full compliance with the consent orders and support the development of national servicing standards that will provide greater clarity for servicers, investors and customers. We continue to be committed to modifying mortgages for at-risk customers. We have been working with our regulators for an extended period to improve our processes and have already made some of the operational changes that will result from the expanded servicing responsibilities outlined in the consent orders. These orders incorporate remedial requirements for identified deficiencies; however, civil money penalties have not been assessed at this time. Changes in servicing and foreclosure practices will increase the Company’s costs of servicing mortgage loans. As part of our quarterly MSR valuation process, we assess changes in expected future servicing and foreclosure costs, which in the first nine
months of 2011, includes the estimated impact from the regulatory consent orders.
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Asset/Liability Management
Asset/liability management involves the evaluation, monitoring and management of interest rate risk, market risk, liquidity and funding. The Corporate Asset/Liability Management Committee (Corporate ALCO), which oversees these risks and reports periodically to the Finance Committee of the Board, consists of senior financial and business executives. Each of our principal business groups has its own asset/liability management committee and process linked to the Corporate ALCO process.
INTEREST RATE RISK Interest rate risk, which potentially can have a significant earnings impact, is an integral part of being a financial intermediary. We assess interest rate risk by comparing our most likely earnings plan with various earnings simulations using many interest rate scenarios that differ in the direction of interest rate changes, the degree of change over time, the speed of change and the projected shape of the yield curve. For example, as of September 30, 2011, our most recent simulation indicated estimated earnings at risk of approximately 1.5% of our most likely earnings plan over the next 12 months using a scenario in which the federal funds rate remains unchanged and the 10-year Constant Maturity Treasury bond yield averages below 2.00%. Simulation estimates depend on, and will change with, the size and mix of our actual and projected balance sheet at the time of each simulation. Due to timing differences between the quarterly valuation of MSRs and the eventual impact of interest rates on mortgage banking volumes, earnings at risk in any particular quarter could be higher than the average earnings at risk over the 12-month simulation period, depending on the path of interest rates and on our hedging strategies for MSRs. See the “Risk Management – Mortgage Banking Interest Rate and Market Risk” section in this Report for more information.
We use exchange-traded and over-the-counter (OTC) interest rate derivatives to hedge our interest rate exposures. The notional or contractual amount, credit risk amount and estimated net fair value of these derivatives as of September 30, 2011, and December 31, 2010, are presented in Note 12 (Derivatives) to Financial Statements in this Report.
For additional information regarding interest rate risk, see page 76 of our 2010 Form 10-K.
MORTGAGE BANKING INTEREST RATE AND MARKET RISK We originate, fund and service mortgage loans, which subjects us to various risks, including credit, liquidity and interest rate risks. For a discussion of mortgage banking interest rate and market risk, see pages 76-78 of our 2010 Form 10-K.
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 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 $13.8 billion at September 30, 2011, and $15.9 billion at December 31, 2010. The weighted-average note rate on our portfolio of loans serviced for others was 5.21% at September 30, 2011, and 5.39% at December 31, 2010. Our total MSRs represented 0.74% of mortgage loans serviced for others at September 30, 2011, and 0.86% at December 31, 2010.
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. We are exposed to market risk through customer accommodation trading, certain economic hedges classified as trading positions and, to a lesser extent, proprietary trading. Trading positions and related market risk exposure are subject to risk limits established and monitored by the Market Risk Committee and Corporate ALCO. These trading positions consist of both securities and derivative instruments. The primary purpose of our trading businesses is to accommodate customers in management of their market price risk. Net gains (losses) from trading activities are attributable to the following types of activity:
Table 31: Trading Activities
Customer accommodation
Economic hedging
Proprietary
Total net trading gains (losses)
The amounts reflected in the table above capture only gains (losses) due to changes in fair value of our trading positions and are reported within net gains (losses) on trading activities within noninterest income line item of the income statement. These amounts do not include interest income and other fees earned from related activities, which are reported within interest income from trading assets and other fees within noninterest income line items of the income statement. Categorization of net gains (losses) from trading activities in the table above is based on our own definition of those categories, as further described below, because no uniform industry definitions currently exist.
Customer accommodation trading consists of security or derivative transactions conducted in an effort to help customers manage their market price risks and are done on their behalf or driven by their investment needs. For the majority of our customer accommodation trading we serve as intermediary between buyer and seller. For example, we may enter into financial instruments with customers that use the instruments for risk management purposes and offset our exposure on such contracts by entering into separate instruments. Customer accommodation trading also includes net gains related to
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Risk Management – Asset/Liability Management (continued)
market-making activities in which we take positions to facilitate expected customer order flow.
Economic hedges consist primarily of cash or derivative positions used to facilitate certain of our balance sheet risk management activities that did not qualify for hedge accounting or were not designated in a hedge accounting relationship. Economic hedges may also include securities that we elected to carry at fair value with changes in fair value recorded to earnings in order to mitigate accounting measurement mismatches or avoid embedded derivative accounting complexities. Third quarter 2011 economic hedge trading results included a loss associated with a legacy Wachovia position that settled in October 2011.
Proprietary trading consists of security or derivative positions executed for our own account based on market expectations or to benefit from price differences between financial instruments and markets. Proprietary trading activity is expected to be restricted by the Dodd-Frank Act prohibitions known as the “Volcker Rule,” which has not yet been finalized. On October 11, 2011, federal banking agencies and the SEC issued for public comment proposed regulations to implement the Volcker Rule. We believe our definition of proprietary trading is consistent with the proposed regulations. However, given that final rule-making is required by various governmental regulatory agencies to define proprietary trading within the context of the final “Volcker Rule,” our definition of proprietary trading may change. We have reduced or exited certain business activities in anticipation of the final “Volcker Rule.” As discussed within the noninterest income section of our financial results, proprietary trading activity is not significant to our financial results.
The fair value of our trading derivatives is reported in Notes 12 (Derivatives) and 13 (Fair Value) to Financial Statements in this Report. The fair value of our trading securities is reported in Note 13 (Fair Value) to Financial Statements in this Report.
The standardized approach for monitoring and reporting market risk for the trading activities consists of value-at-risk (VaR) metrics complemented with sensitivity analysis and stress testing. VaR measures the worst expected loss over a given time interval and within a given confidence interval. We measure and report daily VaR at a 99% confidence interval based on actual changes in rates and prices over the previous 250 trading days. The analysis captures all financial instruments that are considered trading positions. The average one-day VaR throughout third quarter 2011 was $30 million, with a lower bound of $22 million and an upper bound of $40 million.
MARKET RISK – EQUITY MARKETS We are directly and indirectly affected by changes in the equity markets. For additional information regarding market risk related to equity markets, see page 79 of our 2010 Form 10-K.
Table 32 provides information regarding our marketable and nonmarketable equity investments.
Table 32: Nonmarketable and Marketable Equity Investments
Nonmarketable equity investments:
Private equity investments:
Cost method
Equity method
Federal bank stock
Principal investments
Total nonmarketable equity investments (1)
Marketable equity securities:
Cost
Net unrealized gains
Total marketable equity securities (2)
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LIQUIDITY AND FUNDING The objective of effective liquidity management is to ensure that we can meet customer loan requests, customer deposit maturities/withdrawals and other cash commitments efficiently under both normal operating conditions and under unpredictable circumstances of industry or market stress. To achieve this objective, the Corporate ALCO establishes and monitors liquidity guidelines that require sufficient asset-based liquidity to cover potential funding requirements and to avoid over-dependence on volatile, less reliable funding markets. We set these guidelines for both the consolidated balance sheet and for the Parent to ensure that the Parent is a source of strength for its regulated, deposit-taking banking subsidiaries.
Unencumbered debt and equity securities in the securities available-for-sale portfolio provide asset liquidity, in addition
to the immediately liquid resources of cash and due from banks and federal funds sold, securities purchased under resale agreements and other short-term investments. Asset liquidity is further enhanced by our ability to sell or securitize loans in secondary markets and to pledge loans to access secured borrowing facilities through the Federal Home Loan Banks (FHLB) and the FRB.
Core customer deposits have historically provided a sizeable source of relatively stable and low-cost funds. At September 30, 2011, core deposits funded 111% of total loans compared with 102% a year ago. Additional funding is provided by long-term debt, other foreign deposits, and short-term borrowings.
Table 33 shows selected information for short-term borrowings, which generally mature in less than 30 days.
Table 33: Short-Term Borrowings
Commercial paper and other short-term borrowings
Federal funds purchased and securities sold under agreements to repurchase
Average daily balance for period
Maximum month-end balance for period
Commercial paper and other short-term borrowings (1)
Federal funds purchased and securities sold under agreements to repurchase (2)
Liquidity is also available through our ability to raise funds in a variety of domestic and international money and capital markets. We access capital markets for long-term funding through issuances of registered debt securities, private placements and asset-backed secured funding. Investors in the long-term capital markets generally will consider, among other factors, a company’s debt rating in making investment decisions. Rating agencies base their ratings on many quantitative and qualitative factors, including capital adequacy, liquidity, asset quality, business mix, the level and quality of earnings, and rating agency assumptions regarding the probability and extent of Federal financial assistance or support for certain large financial institutions. Adverse changes in these factors could result in a reduction of our credit rating; however, a reduction in credit rating would not cause us to violate any of our debt covenants. On September 21, 2011, Moody’s Investors Service, Inc. downgraded the Parent’s supported long-term senior debt rating based on their determination that, as a result of the Dodd-Frank Act, the U.S. government is less likely to support systemically important financial institutions, if needed, than during the recent financial crisis. The outlook on the Parent’s supported long-term senior rating remains negative based on the possibility that Moody’s may further reduce its
assumptions about the likelihood of systemic support for systemically important financial institutions. See the “Risk Factors” section in our 2011 Second Quarter Form 10-Q for additional information regarding the potential effect of the Dodd-Frank Act on our credit ratings and the risks associated with adverse changes in our credit ratings.
We continue to evaluate the potential impact on liquidity management of regulatory proposals, including Basel III and those required under the Dodd-Frank Act, throughout the rule-making process.
Parent Under SEC rules, the Parent is classified as a “well-known seasoned issuer,” which allows it to file a registration statement that does not have a limit on issuance capacity. In June 2009, the Parent filed a registration statement with the SEC for the issuance of senior and subordinated notes, preferred stock and other securities. The Parent’s ability to issue debt and other securities under this registration statement is limited by the debt issuance authority granted by the Board. The Parent is currently authorized by the Board to issue $60 billion in outstanding short-term debt and $170 billion in outstanding long-term debt. During the first nine months of 2011, the Parent issued $6.6 billion in registered senior notes. In February 2011, the Parent remarketed $2.5 billion of junior subordinated notes
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owned by an unconsolidated, wholly owned trust. The purchasers of the junior subordinated notes exchanged them with the Parent for newly issued senior notes, which are included in the Parent issuances described above. Proceeds of the remarketed junior subordinated notes were used by the trust to purchase $2.5 billion of Class A, Series I Preferred Stock issued by the Parent.
Parent’s proceeds from securities issued in the first nine months of 2011 were used for general corporate purposes, and, unless otherwise specified in the applicable prospectus or prospectus supplement, we expect the proceeds from securities issued in the future will be used for the same purposes.
Table 34 provides information regarding the Parent’s medium-term note (MTN) programs. The Parent may issue senior and subordinated debt securities under Series I & J, and the European and Australian programmes. Under Series K, the Parent may issue senior debt securities linked to one or more indices.
Table 34: Medium-Term Note (MTN) Programs
Date
established
issuance
authority
for
MTN program:
Series I & J (1)
Series K (1)
European (2)
Australian (2) (3)
Wells Fargo Bank, N.A. Wells Fargo Bank, N.A. is authorized by its board of directors to issue $100 billion in outstanding short-term debt and $125 billion in outstanding long-term debt. At September 30, 2011, Wells Fargo Bank, N.A. had available $100 billion in short-term debt issuance authority and $103.7 billion in long-term debt issuance authority.
Wells Fargo Financial Canada Corporation In January 2010, Wells Fargo Financial Canada Corporation (WFFCC), an indirect wholly owned Canadian subsidiary of the Parent, qualified with the Canadian provincial securities commissions CAD$7.0 billion in medium-term notes for distribution from time to time in Canada. During the first nine months of 2011, WFFCC issued CAD$500 million in medium-term notes. At September 30, 2011, CAD$6.5 billion remained available for future issuance. All medium-term notes issued by WFFCC are unconditionally guaranteed by the Parent.
FEDERAL HOME LOAN BANK MEMBERSHIP We are a member of the Federal Home Loan Banks based in Dallas, Des Moines and San Francisco (collectively, the FHLBs). Each member of each of the FHLBs is required to maintain a minimum investment in capital stock of the applicable FHLB. The board of directors of each FHLB can increase the minimum investment requirements in the event it has concluded that additional capital is required to allow it to meet its own regulatory capital requirements. Any increase in the minimum investment requirements outside of specified ranges requires the approval of the Federal Housing Finance Board. Because the extent of any obligation to increase our investment in any of the FHLBs depends entirely upon the occurrence of a future event, potential future payments to the FHLBs are not determinable.
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Capital Management
We have an active program for managing stockholders’ equity and regulatory capital and we maintain a comprehensive process for assessing the Company’s overall capital adequacy. We generate capital internally primarily through the retention of earnings net of dividends. Our objective is to maintain capital levels at the Company and its bank subsidiaries above the regulatory “well-capitalized” thresholds by an amount commensurate with our risk profile and risk tolerance objectives. Our potential sources of stockholders’ equity include retained earnings and issuances of common and preferred stock. Retained earnings increased $9.2 billion from December 31, 2010, predominantly from Wells Fargo net income of $11.8 billion, less common and preferred stock dividends of $2.5 billion. During the first nine months of 2011, we issued approximately 69 million shares of common stock, with net proceeds of $1.0 billion.
On March 18, 2011, the Company was notified by the FRB that it did not object to the capital plan the Company submitted on January 7, 2011, as part of the Comprehensive Capital Analysis and Review (CCAR). Since that notification, the Company has initiated several capital actions, including increasing the quarterly common stock dividend to $0.12 a share, authorizing the repurchase of an additional 200 million shares of our common stock, and issuing notice to call $9.2 billion of trust preferred securities, of which $5.8 billion were called in third quarter 2011 and redeemed in October 2011, that will no longer count as Tier 1 capital under the Dodd-Frank Act and the proposed Basel III capital standards. Consistent with the CCAR process and the FRB’s existing supervisory guidance regarding internal capital assessment, planning and adequacy, the FRB recently proposed rules that will require large bank holding companies such as the Company to submit annual capital plans to the FRB and to provide prior notice to the FRB before making a capital distribution under certain circumstances, including if the FRB objected to a capital plan or if certain minimum capital requirements were not maintained. Under existing FRB supervisory guidance, the Company expects to submit its 2012 annual capital plan as part of the CCAR submission to the FRB in early 2012.
From time to time the Board authorizes the Company to repurchase shares of our common stock. Although we announce when the Board authorizes share repurchases, we typically do not give any public notice before we repurchase our shares. Future stock repurchases may be private or open-market repurchases, including block transactions, accelerated or delayed block transactions, forward transactions, and similar transactions. Additionally, we may enter into plans to purchase stock that satisfy the conditions of Rule 10b5-1 of the Securities Exchange Act of 1934. Various factors determine the amount and timing of our share repurchases, including our capital requirements, the number of shares we expect to issue for acquisitions and employee benefit plans, market conditions (including the trading price of our stock), and regulatory and legal considerations.
In 2008, the Board authorized the repurchase of up to 25 million additional shares of our outstanding common stock. In first quarter 2011, the Board authorized the repurchase of an additional 200 million shares. During third quarter 2011, we repurchased 22 million shares of our common stock in the open market and from our employee benefit plans, and we entered into a $150 million private forward purchase transaction that will settle in fourth quarter 2011 for an estimated 6 million shares of common stock. At September 30, 2011, we had utilized all previously remaining common stock repurchase authority from the 2008 authorization and had remaining authority from the 2011 authorization to purchase approximately 144 million shares. For more information about share repurchases during third quarter 2011, see Part II, Item 2 of this Report.
Historically, our policy has been to repurchase shares under the “safe harbor” conditions of Rule 10b-18 of the Securities Exchange Act of 1934 including a limitation on the daily volume of repurchases. Rule 10b-18 imposes an additional daily volume limitation on share repurchases during a pending merger or acquisition in which shares of our stock will constitute some or all of the consideration. Our management may determine that during a pending stock merger or acquisition when the safe harbor would otherwise be available, it is in our best interest to repurchase shares in excess of this additional daily volume limitation. In such cases, we intend to repurchase shares in compliance with the other conditions of the safe harbor, including the standing daily volume limitation that applies whether or not there is a pending stock merger or acquisition.
In connection with our participation in the Troubled Asset Relief Program (TARP) Capital Purchase Program (CPP), we issued to the U.S. Treasury Department warrants to purchase 110,261,688 shares of our common stock with an exercise price of $34.01 per share expiring on October 28, 2018. The Board has authorized the repurchase by the Company of up to $1 billion of the warrants. On May 26, 2010, in an auction by the U.S. Treasury, we purchased 70,165,963 of the warrants at a price of $7.70 per warrant. We have purchased an additional 818,416 warrants since the U.S. Treasury auction, 167,172 of which were purchased during the third quarter 2011. At September 30, 2011, there were 39,277,309 warrants outstanding and exercisable and $453 million of unused warrant repurchase authority. Depending on market conditions, we may purchase from time to time additional warrants and/or our outstanding debt securities in privately negotiated or open market transactions, by tender offer or otherwise.
Subsequent to the remarketing of certain junior subordinated notes issued in connection with Wachovia’s 2006 issuance of 5.80% fixed-to-floating rate trust preferred securities, the Company issued 25,010 shares of Class A, Series I Preferred Stock, with a par value of $2.5 billion to Wachovia Capital Trust III (Trust), an unconsolidated wholly owned trust. The action completed the Company’s and the Trust’s obligations under an agreement dated February 1, 2006, as amended, between the Trust and the Company (as successor to Wachovia Corporation).
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Capital Management (continued)
The Company and each of our subsidiary banks are subject to various regulatory capital adequacy requirements administered by the FRB and the OCC. Risk-based capital (RBC) guidelines establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. At September 30, 2011, the Company and each of our subsidiary banks were “well-capitalized” under applicable regulatory capital adequacy guidelines. See Note 19 (Regulatory and Agency Capital Requirements) to Financial Statements in this Report for additional information.
Current regulatory RBC rules are based primarily on broad credit-risk considerations and limited market-related risks, but do not take into account other types of risk a financial company may be exposed to. Our capital adequacy assessment process contemplates a wide range of risks that the Company is exposed to and also takes into consideration our performance under a variety of stressed economic conditions, as well as regulatory expectations and guidance, rating agency viewpoints and the view of capital market participants.
In July 2009, the Basel Committee on Bank Supervision published an additional set of international guidelines for review known as Basel III and finalized these guidelines in December 2010. The additional guidelines were developed in response to the financial crisis of 2008 and 2009 and address many of the weaknesses identified in the banking sector as contributing to the crisis including excessive leverage, inadequate and low quality capital and insufficient liquidity buffers. The guidelines, among other things, increase minimum capital requirements and when fully phased in require bank holding companies to maintain a minimum ratio of Tier 1 common equity to risk-weighted assets of at least 7.0%. The U.S. regulatory bodies are reviewing the final international standards and final U.S. rulemaking is expected to be completed in 2011. The Basel Committee recently proposed additional Tier 1 common equity surcharge requirements for global systemically important banks ranging from 1% to 3.5% depending on the bank’s systemic importance to be determined under an indicator-based approach that would consider five broad categories including cross-jurisdictional activity, size, inter-connectedness, substitutability and complexity. These additional capital requirements, which would be phased in beginning in January 2016 and become fully effective on January 1, 2019, would be in addition to the Basel III 7.0% Tier 1 common equity requirement finalized in December 2010. The Financial Stability Board recently determined that we are one of the initial 29 global systemically important banks that would be subject to the surcharge, but has not yet determined the surcharge amount for us and the other banks. The Dodd-Frank Act also requires the FRB to adopt rules subjecting large bank holding companies, such as the Company, to more stringent capital requirements, including stress testing requirements and enhanced capital and liquidity requirements, and these rules may be similar to or more restrictive than those proposed by the Basel Committee. Although uncertainty exists regarding final capital rules, including the FRB’s approach to capital requirements, we evaluate the impact of Basel III on our capital ratios based on our interpretation of the proposed capital requirements and we estimate that our Tier 1 common equity ratio under the Basel III proposal exceeded the fully phased-in minimum of 7.0% by 41 basis points at the end of third quarter
2011. This estimate is subject to change depending on final promulgation of Basel III capital rulemaking and interpretations thereof by regulatory authorities.
We are well underway toward Basel II and Basel III implementation and are currently on schedule to enter the “parallel run phase” of Basel II in 2012 with regulatory approval. During the “parallel run phase,” banks must successfully complete at least a four quarter evaluation period under supervision from regulatory agencies in order to be compliant with the Basel II final rule. Our delayed entry into the “parallel run phase” was approved by the FRB in 2010 as a result of the acquisition of Wachovia.
At September 30, 2011, stockholders’ equity and Tier 1 common equity levels were higher than the quarter ended prior to the Wachovia acquisition. During 2009, as regulators and the market focused on the composition of regulatory capital, the Tier 1 common equity ratio gained significant prominence as a metric of capital strength. There is no mandated minimum or “well-capitalized” standard for Tier 1 common equity; instead the RBC rules state voting common stockholders’ equity should be the dominant element within Tier 1 common equity. Tier 1 common equity was $91.9 billion at September 30, 2011, or 9.34% of risk-weighted assets, an increase of $10.6 billion from December 31, 2010. Table 35 and Table 36 provide the details of the Tier 1 common equity calculation under Basel I and as estimated under Basel III, respectively.
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Table 35: Tier 1 Common Equity Under Basel I (1)
Noncontrolling interests
Total Wells Fargo stockholders’ equity
Adjustments:
Preferred equity (2)
Goodwill and intangible assets (other than MSRs)
Applicable deferred taxes
MSRs over specified limitations
Cumulative other comprehensive income
Tier 1 common equity
Total risk-weighted assets (3)
Tier 1 common equity to total risk-weighted assets
Table 36: Tier 1 Common Equity Under Basel III (Estimated) (1)
Tier 1 common equity under Basel I
Adjustments from Basel I to Basel III:
Cumulative other comprehensive income (2)
Threshold deductions defined under Basel III (2) (3)
Tier 1 common equity under Basel III
Total risk-weighted assets anticipated under Basel III (4)
Tier 1 common equity to total risk-weighted assets anticipated under Basel III
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Critical Accounting Policies
Our significant accounting policies (see Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2010 Form 10-K) are fundamental to understanding our results of operations and financial condition because they require that we use estimates and assumptions that may affect the value of our assets or liabilities and financial results. Six of these policies are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. These policies govern:
the allowance for credit losses;
purchased credit-impaired (PCI) loans;
the valuation of residential mortgage servicing rights (MSRs);
liability for mortgage loan repurchase losses;
the fair valuation of financial instruments; and
income taxes.
Management has reviewed and approved these critical accounting policies and has discussed these policies with the Board’s Audit and Examination Committee. These policies are described further in the “Financial Review – Critical Accounting Policies” section and Note 1 (Summary of Significant Accounting Policies) to Financial Statements in our 2010 Form 10-K.
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Current Accounting Developments
The following accounting pronouncements have been issued by the Financial Accounting Standards Board (FASB) but are not yet effective:
Accounting Standards Update (ASU or Update) 2011-08, Testing Goodwill for Impairment;
ASU 2011-05, Presentation of Comprehensive Income;
ASU 2011-4, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs; and
ASU 2011-3, Reconsideration of Effective Control for Repurchase Agreements.
ASU 2011-08 provides entities with the option to perform a qualitative assessment of goodwill to test for impairment. If, based on qualitative reviews, a company concludes that more likely than not a reporting unit’s fair value is less than its carrying amount, then the company must complete quantitative steps to determine if there is goodwill impairment. If a company concludes otherwise, quantitative tests are not required. We will early adopt this Update in fourth quarter 2011 with no effect on our consolidated financial statements.
ASU 2011-05 eliminates the option for companies to include the components of other comprehensive income in the statement of changes in stockholders’ equity. This Update requires entities to present the components of comprehensive income in either a single statement or in two separate statements, with the statement of other comprehensive income immediately following the statement of income. This Update is currently expected to be effective for us in first quarter 2012 with retrospective application. Early adoption is permitted. This Update will not affect our financial results as it amends only the presentation of comprehensive income.
ASU 2011-04 modifies accounting guidance and expands existing disclosure requirements for fair value measurements. This Update clarifies how fair values should be measured for instruments classified in stockholders’ equity and under what circumstances premiums and discounts should be applied in fair value measurements. This Update also permits entities to measure fair value on a net basis for financial instruments that are managed based on net exposure to market risks and/or counterparty credit risk. Required new disclosures for financial instruments classified as Level 3 include: 1) quantitative information about unobservable inputs used in measuring fair value, 2) qualitative discussion of the sensitivity of fair value measurements to changes in unobservable inputs, and 3) a description of valuation processes used. This Update also requires disclosure of fair value levels for financial instruments that are not recorded at fair value but for which fair value is required to be disclosed. This Update is effective for us in first quarter 2012 with prospective application. Early adoption is not permitted. We are evaluating the effect these accounting changes may have on our consolidated financial statements.
ASU 2011-03 amends the criteria companies use to determine if repurchase and similar agreements should be accounted for as sales or financings. Specifically, this Update removes the criterion for transferors to have the ability to meet contractual obligations through collateral maintenance provisions, even if transferees fail to return transferred assets pursuant to the agreements. This Update is effective for us in first quarter 2012 with prospective application to new transactions and existing transactions modified on or after January 1, 2012. Early adoption is not permitted. We do not expect these accounting changes to have a material effect on our consolidated financial statements.
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Forward-Looking Statements
This Report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects,” “target,” “projects,” “outlook,” “forecast,” “will,” “may,” “could,” “should,” “can” and similar references to future periods. Examples of forward-looking statements in this Report include, but are not limited to, statements we make about: (i) future results of the Company, including the potential effect of recent strong loan and deposit growth on future financial performance; (ii) our targeted noninterest expense for fourth quarter 2012 as part of our expense management initiatives; (iii) future credit quality and expectations regarding future loan losses in our loan portfolios and life-of-loan estimates; the level and loss content of NPAs and nonaccrual loans; the adequacy of the allowance for credit losses, including our current expectation of future reductions in the allowance for credit losses; and the reduction or mitigation of risk in our loan portfolios and the effects of loan modification programs; (iv) our expectations regarding the completion of the remaining Wachovia integration activities; (v) future capital levels and our estimate regarding our Tier 1 common equity ratio under proposed Basel III capital standards as of September 30, 2011; (vi) our current expectation of fourth quarter 2011 net interest income, noninterest expense, mortgage-related revenues and benefits to net interest income and net interest margin from the redemption of trust preferred securities; (vii) our mortgage repurchase exposure and exposure relating to our mortgage foreclosure practices; (viii) the expected outcome and impact of legal, regulatory and legislative developments, including the Dodd-Frank Act and FRB restrictions on debit interchange fees, including earnings expectations regarding mitigation efforts; and (ix) the Company’s plans, objectives and strategies, including our belief that we have more opportunity to increase cross-sell of our products.
Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. Our actual results may differ materially from those contemplated by the forward-looking statements. We caution you, therefore, against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. While there is no assurance that any list of risks and uncertainties or risk factors is complete, important factors that could cause actual results to differ materially from those in the forward-looking statements include the following, without limitation:
current and future economic and market conditions, including the effects of further declines in housing prices, high unemployment rates, U. S. fiscal debt and budget matters, and the sovereign debt crisis in Europe;
our capital and liquidity requirements (including under regulatory capital standards, such as the proposed Basel III capital standards, as determined and interpreted by
applicable regulatory authorities) and our ability to generate capital internally or raise capital on favorable terms;
financial services reform and other current, pending or future legislation or regulation that could have a negative effect on our revenue and businesses, including the Dodd-Frank Act and legislation and regulation relating to overdraft fees (and changes to our overdraft practices as a result thereof), debit card interchange fees, credit cards, and other bank services, as well as the extent of our ability to offset the loss of revenue and income from financial services reform and other legislation and regulation;
legislative proposals to allow mortgage cram-downs in bankruptcy or require other loan modifications;
the extent of our success in our loan modification efforts, as well as the effects of regulatory requirements or guidance regarding loan modifications or changes in such requirements or guidance;
the amount of mortgage loan repurchase demands that we receive and our ability to satisfy any such demands without having to repurchase loans related thereto or otherwise indemnify or reimburse third parties, and the credit quality of or losses on such repurchased mortgage loans;
negative effects relating to mortgage foreclosures, including changes in our procedures or practices and/or industry standards or practices, regulatory or judicial requirements, penalties or fines, increased servicing and other costs or obligations, including loan modification requirements, or delays or moratoriums on foreclosures;
our ability to realize our noninterest expense target as part of our expense management initiatives when and in the amount targeted, including as a result of business and economic cyclicality, seasonality, changes in our business composition and operating environment, growth in our businesses and/or acquisitions, and unexpected expenses relating to, among other things, litigation and regulatory matters;
our ability to successfully integrate the Wachovia merger and realize all of the expected cost savings and other benefits and the effects of any delays or disruptions in systems conversions relating to the Wachovia integration;
recognition of OTTI on securities held in our available-for-sale portfolio;
the effect of changes in interest rates on our net interest margin and our mortgage originations, MSRs and MHFS;
hedging gains or losses;
disruptions in the capital markets and reduced investor demand for mortgage loans;
our ability to sell more products to our customers;
the effect of economic conditions on the demand for our products and services;
the effect of a fall in stock market prices on our investment banking business and our fee income from our brokerage, asset and wealth management businesses;
our election to provide support to our mutual funds for structured credit products they may hold;
changes in the value of our venture capital investments;
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changes in our accounting policies or in accounting standards or in how accounting standards are to be applied or interpreted;
mergers, acquisitions and divestitures;
changes in the Company’s credit ratings and changes in the credit quality of the Company’s customers or counterparties;
reputational damage from negative publicity, fines, penalties and other negative consequences from regulatory violations and legal actions;
a failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks;
the loss of checking and savings account deposits to other investments such as the stock market, and the resulting increase in our funding costs and impact on our net interest margin;
fiscal and monetary policies of the FRB; and
the other risk factors and uncertainties described under “Risk Factors” in our 2011 Second Quarter Form 10-Q and in this Report.
In addition to the above factors, we also caution that there is no assurance that our allowance for credit losses will be adequate to cover future credit losses, especially if housing prices and unemployment do not stabilize or improve. Increases in loan charge-offs or in the allowance for credit losses and related provision expense could materially adversely affect our financial results and condition.
Any forward-looking statement made by us in this Report speaks only as of the date on which it is made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
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Risk Factors
An investment in the Company involves risk, including the possibility that the value of the investment could fall substantially and that dividends or other distributions on the investment could be reduced or eliminated. We discuss previously under “Forward-Looking Statements” and elsewhere in this Report, as well as in other documents we file with the SEC, risk factors that could adversely affect our financial results and condition and the value of, and return on, an investment in the Company. For a discussion of risk factors, we refer you to the “Risk Factors” section of our 2011 Second Quarter Form 10-Q, which amended and restated in their entirety the risk factors set forth in the “Risk Factors” section on pages 92 through 101 of our 2010 Form 10-K, as well as to the Financial Review section and Financial Statements (and related Notes) in this Report for more information about credit, interest rate, market, and litigation risks and to the “Regulation and Supervision” section of our 2010 Form 10-K for more information about legislative and regulatory risks.
In addition, the following risk factor supplements and restates the risk factor captioned “We rely on our systems and certain counterparties, and certain failures could materially adversely affect our operations” set forth on page 65 of our 2011 Second Quarter Form 10-Q and should be read in conjunction with the other risk factors in our 2011 Second Quarter Form 10-Q and in this Report.
A failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a large financial institution that serves over 70 million customers through over 9,000 stores, 12,000 ATMs, the Internet and other distribution channels across the U.S. and internationally, we depend on our ability to process, record and monitor a large number of customer transactions on a continuous basis. As our customer base and locations have expanded throughout the U.S. and internationally, and as customer, public and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions and breakdowns. Our business, financial, accounting, data processing systems or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our control. For example, there could be sudden increases in customer transaction volume; electrical or telecommunications outages; natural disasters such as earthquakes, tornados, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and, as described below, cyber attacks. Although we have business continuity plans and other safeguards in place, our business operations may be adversely affected by significant and widespread disruption to our physical
infrastructure or operating systems that support our businesses and customers.
Information security risks for large financial institutions such as Wells Fargo have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. Our banking, brokerage, investment advisory, and capital markets businesses rely on our digital technologies, computer and email systems, software, and networks to conduct their operations. In addition, to access our products and services, our customers may use personal smartphones, tablet PC’s, and other mobile devices that are beyond our control systems. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of Wells Fargo’s or our customers’ confidential, proprietary and other information, or otherwise disrupt Wells Fargo’s or its customers’ or other third parties’ business operations.
Third parties with which we do business or that facilitate our business activities, including exchanges, clearing houses, financial intermediaries or vendors that provide services or security solutions for our operations, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints.
Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, there can be no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats, the prominent size and scale of Wells Fargo and its role in the financial services industry, our plans to continue to implement our Internet banking and mobile banking channel strategies and develop additional remote connectivity solutions to serve our customers when and how they want to be served, our expanded geographic footprint and international presence, the outsourcing of some of our business operations, the continued uncertain global economic environment, and the remaining system and customer account conversions associated with our integration of Wachovia expected to be completed in first quarter 2012. As a result, cybersecurity and the continued development and enhancement of our controls, processes and practices designed to protect our systems, computers, software, data and networks from attack, damage or unauthorized access remain a priority for Wells Fargo. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.
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Disruptions or failures in the physical infrastructure or operating systems that support our businesses and customers, or cyber attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in customer attrition, regulatory fines,
penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our results of operations or financial condition.
Controls and Procedures
Disclosure Controls and Procedures
As required by SEC rules, the Company’s management evaluated the effectiveness, as of September 30, 2011, of the Company’s disclosure controls and procedures. The Company’s chief executive officer and chief financial officer participated in the evaluation. Based on this evaluation, the Company’s chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2011.
Internal Control Over Financial Reporting
Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (GAAP) and includes those policies and procedures that:
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of assets of the Company;
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. No change occurred during third quarter 2011 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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Wells Fargo & Company and Subsidiaries
Consolidated Statement of Income (Unaudited)
Interest income
Mortgages held for sale
Loans held for sale
Other interest income
Total interest income
Interest expense
Other interest expense
Total interest expense
Net interest income
Provision for credit losses
Net interest income after provision for credit losses
Noninterest income
Trust and investment fees
Other fees
Mortgage banking
Net gains (losses) on debt securities available for sale (1)
Net gains from equity investments (2)
Total noninterest income
Noninterest expense
Total noninterest expense
Income before income tax expense
Income tax expense
Net income before noncontrolling interests
Less: Net income from noncontrolling interests
Less: Preferred stock dividends and other
Wells Fargo net income applicable to common stock
Per share information
Earnings per common share
The accompanying notes are an integral part of these statements.
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Consolidated Balance Sheet (Unaudited)
Mortgages held for sale (includes $38,845 and $47,531 carried at fair value)
Loans held for sale (includes $495 and $873 carried at fair value)
Loans (includes $0 and $309 carried at fair value)
Net loans
Mortgage servicing rights:
Measured at fair value
Amortized
Premises and equipment, net
Other assets
Total assets (1)
Liabilities
Noninterest-bearing deposits
Interest-bearing deposits
Accrued expenses and other liabilities
Long-term debt (includes $0 and $306 carried at fair value)
Total liabilities (2)
Equity
Wells Fargo stockholders’ equity:
Preferred stock
Common stock – $1-2/3 par value, authorized 9,000,000,000 shares;issued 5,341,553,681 shares and 5,272,414,622 shares
Additional paid-in capital
Retained earnings
Treasury stock – 69,333,156 shares and 10,131,394 shares
Unearned ESOP shares
Total liabilities and equity
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Consolidated Statement of Changes in Equity and Comprehensive Income (Unaudited)
Balance January 1, 2010
Cumulative effect from change in accounting for VIEs
Cumulative effect from change in accounting for embedded credit derivatives
Comprehensive income:
Other comprehensive income, net of tax:
Translation adjustments
Net unrealized gains on securities available for sale, net of reclassification of $86 million of net gains included in net income
Net unrealized gains on derivatives and hedging activities, net of reclassification of $363 million of net gains on cash flow hedges included in net income
Defined benefit plans adjustment
Total comprehensive income
Common stock issued
Common stock repurchased
Preferred stock issued to ESOP
Preferred stock released by ESOP
Preferred stock converted to common shares
Common stock warrants repurchased
Common stock dividends
Preferred stock dividends
Tax benefit upon exercise of stock options
Stock incentive compensation expense
Net change in deferred compensation and related plans
Net change
Balance September 30, 2010
Balance January 1, 2011
Net unrealized losses on securities available for sale,net of reclassification of $382 million of net gains included in net income
Net unrealized losses on derivatives and hedging activities,net of reclassification of $10 million of net gains on cash flow hedges included in net income
Common stock repurchased (1)
Preferred stock issued
Balance September 30, 2011
(1) Includes $150 million private forward repurchase contract. See Note 1 (Summary of Significant Accounting Policies) for additional information.
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65
Consolidated Statement of Cash Flows (Unaudited)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Changes in fair value of MSRs, MHFS and LHFS carried at fair value
Depreciation and amortization
Other net losses
Excess tax benefits related to stock option payments
Originations of MHFS
Proceeds from sales of and principal collected on mortgages originated for sale
Originations of LHFS
Proceeds from sales of and principal collected on LHFS
Purchases of LHFS
Net change in:
Deferred income taxes
Accrued interest receivable
Accrued interest payable
Other assets, net
Other accrued expenses and liabilities, net
Net cash provided by operating activities
Cash flows from investing activities:
Securities available for sale:
Sales proceeds
Prepayments and maturities
Purchases
Loans originated by banking subsidiaries, net of principal collected
Proceeds from sales (including participations) of loans originated for investment by banking subsidiaries
Purchases (including participations) of loans by banking subsidiaries
Principal collected on nonbank entities’ loans
Loans originated by nonbank entities
Net cash paid for acquisitions
Proceeds from sales of foreclosed assets
Changes in MSRs from purchases and sales
Other, net
Net cash provided (used) by investing activities
Cash flows from financing activities:
Long-term debt:
Proceeds from issuance
Repayment
Preferred stock:
Cash dividends paid
Common stock:
Repurchased
Net change in noncontrolling interests
Net cash provided (used) by financing activities
Net change in cash and due from banks
Cash and due from banks at beginning of period
Cash and due from banks at end of period
Supplemental cash flow disclosures:
Cash paid for interest
Cash paid for income taxes
The accompanying notes are an integral part of these statements. See Note 1 for noncash activities.
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See the Glossary of Acronyms at the end of this Report for terms used throughout the Financial Statements and related Notes of this Form 10-Q.
Note 1: Summary of Significant Accounting Policies
Wells Fargo & Company is a diversified financial services company. We provide banking, insurance, trust and investments, mortgage banking, investment banking, retail banking, brokerage, and consumer and commercial finance through banking stores, the internet and other distribution channels to consumers, businesses and institutions in all 50 states, the District of Columbia, and in other countries. When we refer to “Wells Fargo,” “the Company,” “we,” “our” or “us” in this Form 10-Q, we mean Wells Fargo & Company and Subsidiaries (consolidated). Wells Fargo & Company (the Parent) is a financial holding company and a bank holding company. We also hold a majority interest in a real estate investment trust, which has publicly traded preferred stock outstanding.
Our accounting and reporting policies conform with U.S. generally accepted accounting principles (GAAP) and practices in the financial services industry. To prepare the financial statements in conformity with GAAP, management must make estimates based on assumptions about future economic and market conditions (for example, unemployment, market liquidity, real estate prices, etc.) that affect the reported amounts of assets and liabilities at the date of the financial statements and income and expenses during the reporting period and the related disclosures. Although our estimates contemplate current conditions and how we expect them to change in the future, it is reasonably possible that actual conditions could be worse than anticipated in those estimates, which could materially affect our results of operations and financial condition. Management has made significant estimates in several areas, including other-than-temporary impairment (OTTI) on investment securities (Note 4), allowance for credit losses and purchased credit-impaired (PCI) loans (Note 5), valuations of residential mortgage servicing rights (MSRs) (Notes 7 and 8) and financial instruments (Note 13), liability for mortgage loan repurchase losses (Note 8) and income taxes. Actual results could differ from those estimates.
The information furnished in these unaudited interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2010 (2010 Form 10-K).
Accounting Standards Adopted in 2011
In first quarter 2011, we adopted certain provisions of Accounting Standards Update (ASU or Update) 2010-6, Improving Disclosures about Fair Value Measurements.
ASU 2010-6 amends the disclosure requirements for fair value measurements. Companies are required to disclose significant transfers in and out of Levels 1 and 2 of the fair value hierarchy. This Update also clarifies that fair value measurement disclosures should be presented for each asset and liability class, which is generally a subset of a line item in the statement of financial position. In the rollforward of Level 3 activity, companies must present information on purchases, sales, issuances, and settlements on a gross basis rather than on a net basis. Companies should also provide information about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring instruments classified as either Level 2 or Level 3. In first quarter 2011, we adopted the requirement for gross presentation in the Level 3 rollforward with prospective application. The remaining provisions were effective for us in first quarter 2010. Our adoption of this Update did not affect our consolidated financial statement results since it amends only the disclosure requirements for fair value measurements.
In third quarter 2011, we adopted the following new accounting guidance:
Certain provisions of ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses; and
ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.
ASU 2010-20 requires enhanced disclosures for the allowance for credit losses and financing receivables, which include certain loans and long-term accounts receivables. Companies are required to disaggregate credit quality information and roll forward the allowance for credit losses by portfolio segment. Companies must also provide supplemental information on the nature and extent of troubled debt restructurings (TDRs) and their effect on the allowance for credit losses. We adopted the new disclosure requirements for TDRs in third quarter 2011 with retrospective application to January 1, 2011. The remaining provisions were effective for us in fourth quarter 2010. Our adoption of this Update did not affect our consolidated financial statement results since it amends only the disclosure requirements for financing receivables and the allowance for credit losses.
ASU 2011-02 provides guidance clarifying under what circumstances a creditor should classify a restructured receivable as a TDR. A receivable is a TDR if both of the following exist: 1) a creditor has granted a concession to the debtor, and 2) the
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Note 1: Summary of Significant Accounting Policies (continued)
debtor is experiencing financial difficulties. This Update clarifies that a creditor should consider all aspects of a restructuring when evaluating whether it has granted a concession, which include determining whether a debtor can obtain funds from another source at market rates and assessing the value of additional collateral and guarantees obtained at the time of restructuring. This Update also provides factors a creditor should consider when determining if a debtor is experiencing financial difficulties, such as probability of payment default and bankruptcy declarations. This guidance was effective for us in third quarter 2011 with retrospective application to January 1, 2011. Our adoption of this Update did not have a material effect on our consolidated financial statements.
Private Share Repurchases
During third quarter 2011, we entered into a private forward repurchase contract with an unrelated third party. This contract is indexed to and expected to settle in our common stock. Additionally, this contract meets accounting requirements to be classified as permanent equity. In connection with the agreement, we paid $150 million to the counterparty, which is recorded in permanent equity and is not subject to re-measurement. In return, the counterparty agreed to deliver a variable number of shares based on our volume weighted average stock price over the contract period. The agreement expires in fourth quarter 2011; however, the counterparty has the right to accelerate settlement with delivery of shares prior to the contractual settlement. There are no scenarios where the contract would not either physically settle in shares or allow us to choose the settlement method. The contract is expected to settle in our common stock unless unlikely events occur.
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SUPPLEMENTAL CASH FLOW INFORMATION Noncash activities are presented below, including information on transfers affecting MHFS, LHFS, and MSRs.
Transfers from loans to securities available for sale
Trading assets retained from securitization of MHFS
Capitalization of MSRs from sale of MHFS
Transfers from MHFS to foreclosed assets
Transfers from loans to MHFS
Transfers from (to) loans to (from) LHFS
Transfers from loans to foreclosed assets
Changes in consolidations of variable interest entities:
Decrease in noncontrolling interests due to deconsolidation of subsidiaries
Transfer from noncontrolling interests to long-term debt
SUBSEQUENT EVENTS We have evaluated the effects of subsequent events that have occurred subsequent to period end September 30, 2011, and there have been no material events that would require recognition in our third quarter 2011 consolidated
financial statements or disclosure in the Notes to the financial statements.
Note 2: Business Combinations
We regularly explore opportunities to acquire financial services companies and businesses. Generally, we do not make a public announcement about an acquisition opportunity until a definitive agreement has been signed. For information on additional consideration related to acquisitions, which is considered to be a guarantee, see Note 10.
In the first nine months of 2011, we completed nine acquisitions with combined total assets of $472 million consisting of a channel finance business with assets of
$389 million, a foreign currency exchange business with assets of $46 million and seven insurance brokerage businesses with combined total assets of $37 million. At September 30, 2011, we had two acquisitions pending, both of which are scheduled to close during fourth quarter 2011 with combined total assets of approximately $165 million. Also, the previously announced divestiture of our H.D. Vest Financial Services business was completed in October 2011.
Note 3: Federal Funds Sold, Securities Purchased under Resale Agreements and Other Short-Term Investments
The following table provides the detail of federal funds sold, securities purchased under resale agreements and other short-term investments.
Federal funds sold and securitiespurchased under resale agreements
Interest-earning deposits
Other short-term investments
We receive collateral from other entities under resale agreements and securities borrowings. For additional information, see Note 10.
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Note 4: Securities Available for Sale
The following table provides the cost and fair value for the major categories of securities available for sale carried at fair value. The net unrealized gains (losses) are reported on an after-tax basis as
a component of cumulative OCI. There were no securities classified as held to maturity as of the dates presented.
September 30, 2011
Residential
Corporate debt securities
Collateralized debt obligations (1)
Total debt securities
Perpetual preferred securities
Other marketable equity securities
Total marketable equity securities
December 31, 2010
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Gross Unrealized Losses and Fair Value
The following table shows the gross unrealized losses and fair value of securities in the securities available-for-sale portfolio by length of time that individual securities in each category had been in a continuous loss position. Debt securities on which we
have taken credit-related OTTI write-downs are categorized as being “less than 12 months” or “12 months or more” in a continuous loss position based on the point in time that the fair value declined to below the cost basis and not the period of time since the credit-related OTTI write-down.
Gross
Collateralized debt obligations
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Note 4: Securities Available for Sale (continued)
We do not have the intent to sell any securities included in the previous table. For debt securities included in the table, we have concluded it is more likely than not that we will not be required to sell prior to recovery of the amortized cost basis. We have assessed each security for credit impairment. For debt securities, we evaluate, where necessary, whether credit impairment exists by comparing the present value of the expected cash flows to the securities’ amortized cost basis. For equity securities, we consider numerous factors in determining whether impairment exists, including our intent and ability to hold the securities for a period of time sufficient to recover the cost basis of the securities.
For complete descriptions of the factors we consider when analyzing debt securities for impairment, see Note 5 in our 2010 Form 10-K. There have been no material changes to our methodologies for assessing impairment in the first nine months of 2011.
SECURITIES OF U.S. TREASURY AND FEDERAL AGENCIES AND FEDERAL AGENCY MORTGAGE-BACKED SECURITIES (MBS) The unrealized losses associated with U.S. Treasury and federal agency securities and federal agency MBS are primarily driven by changes in interest rates and not due to credit losses given the explicit or implicit guarantees provided by the U.S. government.
SECURITIES OF U.S. STATES AND POLITICAL SUBDIVISIONS The unrealized losses associated with securities of U.S. states and political subdivisions are primarily driven by changes in interest rates and not due to the credit quality of the securities. Substantially all of these investments are investment grade. The securities were generally underwritten in accordance with our own investment standards prior to the decision to purchase, without relying on a bond insurer’s guarantee in making the investment decision. These investments will continue to be monitored as part of our ongoing impairment analysis, but are expected to perform, even if the rating agencies reduce the credit rating of the bond insurers. As a result, we expect to recover the entire amortized cost basis of these securities.
RESIDENTIAL AND COMMERCIAL MORTGAGE-BACKED SECURITIES (MBS) The unrealized losses associated with private residential MBS and commercial MBS are primarily driven by changes in projected collateral losses, credit spreads and interest rates. We assess for credit impairment using a cash flow model. The key assumptions include default rates, severities and prepayment rates. We estimate losses to a security by forecasting the underlying mortgage loans in each transaction. We use forecasted loan performance to project cash flows to the various tranches in the structure. We also consider cash flow forecasts and, as applicable, independent industry analyst reports and forecasts, sector credit ratings, and other independent market data. Based upon our assessment of the expected credit losses and the credit enhancement level of the securities, we expect to recover the entire amortized cost basis of these securities.
CORPORATE DEBT SECURITIES The unrealized losses associated with corporate debt securities are primarily related to
unsecured debt obligations issued by various corporations. We evaluate the financial performance of each issuer on a quarterly basis to determine that the issuer can make all contractual principal and interest payments. Based upon this assessment, we expect to recover the entire amortized cost basis of these securities.
COLLATERALIZED DEBT OBLIGATIONS (CDOS) The unrealized losses associated with CDOs relate to securities primarily backed by commercial, residential or other consumer collateral. The unrealized losses are primarily driven by changes in projected collateral losses, credit spreads and interest rates. We assess for credit impairment using a cash flow model. The key assumptions include default rates, severities and prepayment rates. We also consider cash flow forecasts and, as applicable, independent industry analyst reports and forecasts, sector credit ratings, and other independent market data. Based upon our assessment of the expected credit losses and the credit enhancement level of the securities, we expect to recover the entire amortized cost basis of these securities.
OTHER DEBT SECURITIES The unrealized losses associated with other debt securities primarily relate to other asset-backed securities. The losses are primarily driven by changes in projected collateral losses, credit spreads and interest rates. We assess for credit impairment using a cash flow model. The key assumptions include default rates, severities and prepayment rates. Based upon our assessment of the expected credit losses and the credit enhancement level of the securities, we expect to recover the entire amortized cost basis of these securities.
MARKETABLE EQUITY SECURITIES Our marketable equity securities include investments in perpetual preferred securities, which provide very attractive tax-equivalent yields. We evaluated these hybrid financial instruments with investment-grade ratings for impairment using an evaluation methodology similar to that used for debt securities. Perpetual preferred securities are not considered to be other-than-temporarily impaired if there is no evidence of credit deterioration or investment rating downgrades of any issuers to below investment grade, and we expect to continue to receive full contractual payments. We will continue to evaluate the prospects for these securities for recovery in their market value in accordance with our policy for estimating OTTI. We have recorded impairment write-downs on perpetual preferred securities where there was evidence of credit deterioration.
The fair values of our investment securities could decline in the future if the underlying performance of the collateral for the residential and commercial MBS or other securities deteriorate and our credit enhancement levels do not provide sufficient protection to our contractual principal and interest. As a result, there is a risk that significant OTTI may occur in the future.
The following table shows the gross unrealized losses and fair value of debt and perpetual preferred securities available for sale by those rated investment grade and those rated less than investment grade, according to their lowest credit rating by Standard & Poor’s Rating Services (S&P) or Moody’s Investors Service (Moody’s). Credit ratings express opinions about the
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credit quality of a security. Securities rated investment grade, that is those rated BBB- or higher by S&P or Baa3 or higher by Moody’s, are generally considered by the rating agencies and market participants to be low credit risk. Conversely, securities rated below investment grade, labeled as “speculative grade” by the rating agencies, are considered to be distinctively higher credit risk than investment grade securities. We have also included securities not rated by S&P or Moody’s in the table below based on the internal credit grade of the securities (used
for credit risk management purposes) equivalent to the credit rating assigned by major credit agencies. The unrealized losses and fair value of unrated securities categorized as investment grade based on internal credit grades were $182 million and $3.8 billion, respectively, at September 30, 2011, and $83 million and $1.3 billion, respectively, at December 31, 2010. If an internal credit grade was not assigned, we categorized the security as non-investment grade.
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Contractual Maturities
The following table shows the remaining contractual maturities and contractual yields of debt securities available for sale. The remaining contractual principal maturities for MBS do not consider prepayments. Remaining expected maturities will differ
from contractual maturities because borrowers may have the right to prepay obligations before the underlying mortgages mature.
Weighted-
average
Total debt securities at fair value
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Realized Gains and Losses
The following table shows the gross realized gains and losses on sales and OTTI write-downs related to the securities available-for-sale portfolio, which includes marketable equity securities, as well as net realized gains and losses on nonmarketable equity securities (see Note 6 – Other Assets).
Gross realized gains
Gross realized losses
OTTI write-downs
Net realized gains from securities available for sale
Net realized gains from principal and private equity investments
Net realized gains from debt securities and equity investments
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Other-Than-Temporary Impairment
The following table shows the detail of total OTTI write-downs included in earnings for debt securities and marketable and nonmarketable equity securities.
OTTI write-downs included in earnings
Debt securities:
U.S. states and political subdivisions
Other debt securities
Equity securities:
Nonmarketable equity securities
Total OTTI write-downs included in earnings
Other-Than-Temporarily Impaired Debt Securities
The following table shows the detail of OTTI write-downs on debt securities available for sale included in earnings and the related changes in OCI for the same securities.
OTTI on debt securities
Recorded as part of gross realized losses:
Credit-related OTTI
Intent-to-sell OTTI
Total recorded as part of gross realized losses
Recorded directly to OCI for non-credit-related impairment:
Residential mortgage-backed securities
Commercial mortgage-backed securities
Total recorded directly to OCI for increase (decrease) in non-credit-related impairment (1)
Total OTTI losses recorded on debt securities
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The following table presents a rollforward of the credit loss component of OTTI recognized in earnings for debt securities we still own (referred to as “credit-impaired” debt securities). The credit loss component of the amortized cost represents the difference between the present value of expected future cash flows discounted using the security’s current effective interest rate and the amortized cost basis of the security prior to considering credit losses. OTTI recognized in earnings for credit-impaired debt securities is presented as additions and is classified into one of two components based upon whether the current period is the first time the debt security was credit-
impaired (initial credit impairment) or if the debt security was previously credit-impaired (subsequent credit impairments). The credit loss component is reduced if we sell, intend to sell or believe we will be required to sell previously credit-impaired debt securities. Additionally, the credit loss component is reduced if we receive or expect to receive cash flows in excess of what we previously expected to receive over the remaining life of the credit-impaired debt security, the security matures or is fully written down.
Changes in the credit loss component of credit-impaired debt securities that we do not intend to sell were:
Credit loss component, beginning of period
Additions:
Initial credit impairments
Subsequent credit impairments
For securities sold
For securities derecognized due to changes in consolidation status of variable interest entities
Due to change in intent to sell or requirement to sell
For recoveries of previous credit impairments (1)
Credit loss component, end of period
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For asset-backed securities (e.g., residential MBS), we estimated expected future cash flows of the security by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordinated interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which consider current delinquencies and nonperforming assets
(NPAs), future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the security’s current effective interest rate to arrive at a present value amount. Total credit impairment losses on residential MBS that we do not intend to sell are shown in the table below. The table also presents a summary of the significant inputs considered in determining the measurement of the credit loss component recognized in earnings for residential MBS.
Credit impairment losses on residential MBS
Investment grade
Non-investment grade
Total credit impairment losses on residential MBS
Significant inputs (non-agency – non-investment grade MBS)
Expected remaining life of loan losses (1):
Range (2)
Credit impairment distribution (3):
0 - 10% range
10 - 20% range
20 - 30% range
Greater than 30%
Weighted average (4)
Current subordination levels (5):
Prepayment speed (annual CPR (6)):
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Note 5: Loans and Allowance for Credit Losses
The following table presents total loans outstanding by portfolio segment and class of financing receivable. Outstanding balances are presented net of unearned income, net deferred loan fees, and unamortized discounts and premiums totaling a net reduction of $9.3 billion and $11.3 billion at September 30, 2011,
and December 31, 2010, respectively. Outstanding balances also include PCI loans net of any remaining purchase accounting adjustments. Information about PCI loans is presented separately in the “Purchased Credit-Impaired Loans” section of this Note.
The following table summarizes the proceeds paid or received for purchases and sales of loans and transfers from (to) mortgages/loans held for sale at lower of cost or market. This loan activity primarily includes purchases or sales of commercial loan participation interests, whereby we receive or transfer a
portion of a loan after origination. The table excludes PCI loans and loans recorded at fair value, including loans originated for sale because their loan activity normally does not impact the allowance for credit losses.
Purchases (1)
Transfers from/(to) MHFS/LHFS (1)
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Note 5: Loans and Allowance for Credit Losses (continued)
Allowance for Credit Losses (ACL)
The ACL is management’s estimate of credit losses inherent in the loan portfolio, including unfunded credit commitments, at the balance sheet date. We have an established process to determine the adequacy of the allowance for credit losses that assesses the losses inherent in our portfolio and related unfunded credit commitments. While we attribute portions of the allowance to specific portfolio segments, the entire allowance is available to absorb credit losses inherent in the total loan portfolio and unfunded credit commitments.
Our process involves procedures to appropriately consider the unique risk characteristics of our commercial and consumer loan portfolio segments. For each portfolio segment, losses are estimated collectively for groups of loans with similar characteristics, individually for impaired loans or, for PCI loans, based on the changes in cash flows expected to be collected.
Our allowance levels are influenced by loan volumes, loan grade migration or delinquency status, historic loss experience influencing loss factors, and other conditions influencing loss expectations, such as economic conditions.
COMMERCIAL PORTFOLIO SEGMENT ACL METHODOLOGY Generally, commercial loans are assessed for estimated losses by grading each loan using various risk factors as identified through periodic reviews. We apply historic grade-specific loss factors to the aggregation of each funded grade pool. These historic loss factors are also used to estimate losses for unfunded credit commitments. In the development of our statistically derived loan grade loss factors, we observe historical losses over a relevant period for each loan grade. These loss estimates are adjusted as appropriate based on additional analysis of long-term average loss experience compared to previously forecasted losses, external loss data or other risks identified from current economic conditions and credit quality trends.
The allowance also includes an amount for the estimated impairment on nonaccrual commercial loans and commercial loans modified in a TDR, whether on accrual or nonaccrual status.
CONSUMER PORTFOLIO SEGMENT ACL METHODOLOGY For consumer loans, not identified as a TDR, we determine the allowance on a collective basis utilizing forecasted losses to represent our best estimate of inherent loss. We pool loans, generally by product types with similar risk characteristics, such as residential real estate mortgages and credit cards. As appropriate and to achieve greater accuracy, we may further stratify selected portfolios by sub-product, origination channel, vintage, loss type, geographic location and other predictive characteristics. Models designed for each pool are utilized to develop the loss estimates. We use assumptions for these pools in our forecast models, such as historic delinquency and default, loss severity, home price trends, unemployment trends, and other key economic variables that may influence the frequency and severity of losses in the pool.
In determining the appropriate allowance attributable to our residential mortgage portfolio, we incorporate the default rates and high severity of loss for junior lien mortgages behind delinquent first lien mortgages into our loss forecasting
calculations. In addition, the loss rates we use in determining our allowance include the impact of our established loan modification programs. When modifications occur or are probable to occur, our allowance considers the impact of these modifications, taking into consideration the associated credit cost, including re-defaults of modified loans and projected loss severity. Accordingly, the loss content associated with the effects of existing and probable loan modifications and junior lien mortgages behind delinquent first lien mortgages has been captured in our allowance methodology.
We separately estimate impairment for consumer loans that have been modified in a TDR, whether on accrual or nonaccrual status.
OTHER ACL MATTERS The allowance for credit losses for both portfolio segments includes an amount for imprecision or uncertainty that may change from period to period. This amount represents management’s judgment of risks inherent in the processes and assumptions used in establishing the allowance. This imprecision considers economic environmental factors, modeling assumptions and performance, process risk, and other subjective factors, including industry trends and ongoing discussions with regulatory and government agencies regarding mortgage foreclosure-related matters.
Impaired loans, which include nonaccrual commercial loans and any loans that have been modified in a TDR, have an estimated allowance calculated as the difference, if any, between the impaired value of the loan and the recorded investment in the loan. The impaired value of the loan is generally calculated as the present value of expected future cash flows from principal and interest which incorporates expected lifetime losses, discounted at the loan’s effective interest rate. The allowance for a non-impaired loan is based solely on principal losses without consideration for timing of those losses. The allowance for an impaired loan that was modified in a TDR may be lower than the previously established allowance for that loan due to benefits received through modification, such as lower probability of default and/or severity of loss, and the impact of prior charge-offs or charge-offs at the time of the modification that may reduce or eliminate the need for an allowance.
Commercial and consumer PCI loans may require an allowance subsequent to their acquisition. This allowance requirement is due to probable decreases in expected principal and interest cash flows (other than due to decreases in interest rate indices and changes in prepayment assumptions).
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The allowance for credit losses consists of the allowance for loan losses and the allowance for unfunded credit commitments. Changes in the allowance for credit losses were:
Interest income on certain impaired loans (1)
Loan charge-offs:
Total loan charge-offs
Loan recoveries:
Total loan recoveries
Net loan charge-offs (2)
Allowances related to business combinations/other (3)
Allowance for credit losses (4)
Net loan charge-offs (annualized) as a percentage of average total loans (2)
Allowance for loan losses as a percentage of total loans (4)
Allowance for credit losses as a percentage of total loans (4)
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The following table summarizes the activity in the allowance for credit losses by our commercial and consumer portfolio segments.
Interest income on certain impaired loans
Loan charge-offs
Loan recoveries
Net loan charge-offs
Allowance related to business combinations/other
The following table disaggregates our allowance for credit losses and recorded investment in loans by impairment methodology.
Collectively evaluated (1)
Individually evaluated (2)
PCI (3)
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We monitor credit quality as indicated by evaluating various attributes and utilize such information in our evaluation of the adequacy of the allowance for credit losses. The following sections provide the credit quality indicators we most closely monitor. See the “Purchased Credit-Impaired Loans” section of this Note for credit quality information on our PCI portfolio.
The majority of credit quality indicators are based on September 30, 2011, information, with the exception of updated FICO and updated loan-to-value (LTV)/combined LTV (CLTV), which are obtained at least quarterly. Generally, these indicators are updated in the second month of each quarter, with updates no older than June 30, 2011.
COMMERCIAL CREDIT QUALITY INDICATORS In addition to monitoring commercial loan concentration risk, we manage a
consistent process for assessing commercial loan credit quality. Commercial loans are subject to individual risk assessment using our internal borrower and collateral quality ratings. Our ratings are aligned to Pass and Criticized categories. The Criticized category includes Special Mention, Substandard, and Doubtful categories which are defined by banking regulatory agencies.
The table below provides a breakdown of outstanding commercial loans by risk category. Both the CRE mortgage and construction criticized totals are relatively high as a result of the current conditions in the real estate market. Of the $30.0 billion in criticized CRE loans, $6.3 billion has been placed on nonaccrual status and written down to net realizable value. CRE loans have a high level of monitoring in place to manage these assets and mitigate any loss exposure.
By risk category:
Pass
Criticized
Total commercial loans (excluding PCI)
Total commercial PCI loans (carrying value)
Total commercial loans
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In addition, we monitor past due status as part of our credit risk management practices for commercial loans. The following table provides past due information for commercial loans.
By delinquency status:
Current-29 DPD and still accruing
30-89 DPD and still accruing
90+ DPD and still accruing
Nonaccrual loans
CONSUMER CREDIT QUALITY INDICATORS We have various classes of consumer loans that present respective unique risks. Loan delinquency, FICO credit scores and LTV for loan types are common credit quality indicators that we monitor and utilize in our evaluation of the adequacy of the allowance for credit losses for the consumer portfolio segment.
The majority of our loss estimation techniques used for the allowance for credit losses rely on delinquency matrix models or delinquency roll rate models. Therefore, delinquency is an important indicator of credit quality and the establishment of our allowance for credit losses.
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The following table provides the outstanding balances of our consumer portfolio by delinquency status.
Current-29 DPD
30-59 DPD
60-89 DPD
90-119 DPD
120-179 DPD
180+ DPD
Government insured/guaranteed loans (1)
Total consumer loans (excluding PCI)
Total consumer PCI loans (carrying value)
Total consumer loans
December 31, 2010 (2)
Of $11.5 billion of loans that are 90 days or more past due at September 30, 2011, $1.5 billion was accruing, compared with $13.0 billion and $2.0 billion, respectively, at December 31, 2010.
Real estate 1-4 family first mortgage loans 180 days or more past due totaled $6.6 billion, or 3.4% of total first mortgages (excluding PCI), at September 30, 2011, compared with $6.8 billion, or 3.4%, at December 31, 2010. The aging of the delinquent real estate 1-4 family first mortgage loans is a result of the prolonged foreclosure process and our effort to help customers stay in their homes through various loan modification programs, as loans continue to age until these processes are complete.
The following table provides a breakdown of our consumer portfolio by updated FICO. We obtain FICO scores at loan origination and the scores are updated at least quarterly. FICO is not available for certain loan types and may not be obtained if we deem it unnecessary due to strong collateral and other borrower attributes, primarily securities-based margin loans of $5.0 billion at September 30, 2011, and $4.1 billion at December 31, 2010. The majority of our portfolio is underwritten with a FICO score of 680 and above.
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By updated FICO:
< 600
600-639
640-679-
680-719
720-759
760-799
800+
No FICO available
FICO not required
640-679
LTV refers to the ratio comparing the loan’s unpaid principal balance to the property’s collateral value. CLTV refers to the combination of first mortgage and junior lien mortgage (including unused line amounts for credit line products) ratios. LTVs and CLTVs are updated quarterly using a cascade approach which first uses values provided by automated valuation models (AVMs) for the property. If an AVM is not available, then the value is estimated using the original appraised value adjusted by the change in Home Price Index (HPI) for the property location. If an HPI is not available, the original appraised value is used. The HPI value is normally the only method considered for high value properties as the AVM values have proven less accurate for these properties.
The following table shows the most updated LTV and CLTV distribution of the real estate 1-4 family first and junior lien mortgage loan portfolios. In recent years, the residential real estate markets have experienced significant declines in property values and several markets, particularly California and Florida have experienced declines that turned out to be more significant than the national decline. These trends are considered in the way that we monitor credit risk and establish our allowance for credit losses. LTV does not necessarily reflect the likelihood of
performance of a given loan, but does provide an indication of collateral value. In the event of a default, any loss should be limited to the portion of the loan amount in excess of the net realizable value of the underlying real estate collateral value. Certain loans do not have an LTV or CLTV primarily due to industry data availability and portfolios acquired from or serviced by other institutions.
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By LTV/CLTV:
0-60%
60.01-80%
80.01-100%
100.01-120% (2)
> 120% (2)
No LTV/CLTV available
Government insured/guaranteed loans (3)
NONACCRUAL LOANS The following table provides loans on nonaccrual status. PCI loans are excluded from this table due to the existence of the accretable yield.
Total nonaccrual loans (excluding PCI)
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LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING Certain loans 90 days or more past due as to interest or principal are still accruing, because they are (1) well-secured and in the process of collection or (2) real estate 1-4 family mortgage loans or consumer loans exempt under regulatory rules from being classified as nonaccrual until later delinquency, usually 120 days past due. PCI loans of $8.9 billion at September 30, 2011, and $11.6 billion at December 31, 2010, are excluded from this disclosure even though they are 90 days or more contractually past due. These PCI loans are considered to be accruing due to the existence of the accretable yield and not based on consideration given to contractual interest payments.
The following table shows non-PCI loans 90 days or more past due and still accruing by class for loans not government insured/guaranteed.
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IMPAIRED LOANS The table below summarizes key information for impaired loans. Our impaired loans include loans on nonaccrual status in the commercial portfolio segment and loans modified in a troubled debt restructuring (TDR), whether on accrual or nonaccrual status. These impaired loans may have estimated loss which is included in the allowance for credit losses. Impaired loans exclude PCI loans. Upon our adoption of ASU No. 2011-02, we identified commercial loans that were not
previously included as impaired loans, which, at September 30, 2011, totaled $685 million with an associated allowance for credit losses of $54 million. The allowance for credit losses associated with these loans would have been measured under a collectively evaluated basis prior to adoption, but is now estimated on an individually evaluated basis. Our consumer loans were not impacted by the adoption of ASU No. 2011-02.
Total impaired loans (excluding PCI)
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Commitments to lend additional funds on loans whose terms have been modified in a TDR amounted to $3.8 billion at September 30, 2011, and $1.2 billion at December 31, 2010. These commitments primarily relate to commercial and industrial loans, which, at the time of modification, had an amount of availability to the borrower that continues under the
modified terms of the TDR and totaled $2.5 billion at September 30, 2011, and $345 million at December 31, 2010.
The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans by portfolio segment and class.
Total impaired loans
Interest income:
Cash basis of accounting
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TDRS When, for economic or legal reasons related to a borrower’s financial difficulties, we grant a concession for other than an insignificant period of time to a borrower that we would not otherwise consider, the related loan is classified as a TDR. We do not consider any loans modified through a loan resolution
such as foreclosure or short sale to be a TDR. The following table summarizes how our loans were modified as TDRs in the current period, including the financial effects of the modification. The reported balances represent TDRs outstanding at the end of the period.
Quarter ended September 30, 2011
Nine months ended September 30, 2011
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The table below summarizes TDRs that have defaulted in the current period within 12 months of their modification date. We are reporting these defaulted TDRs based on a payment default
definition of 90 days past due for the commercial portfolio segment and 60 days past due for the consumer portfolio segment.
The two previous tables present information for permanent modifications classified as TDRs. We require some borrowers experiencing financial difficulty to make trial payments for three to four months, according to terms of a planned permanent modification, to determine if they can perform according to those terms. These trial payment period arrangements are developed in accordance with our proprietary programs or the U.S. Treasury’s Making Homes Affordable programs for real estate 1-4 family first lien (i.e. Home Affordable Modification Program – HAMP) and junior lien (i.e. Second Lien Modification Program – 2MP) mortgage loans. While loans are in trial payment programs their original terms are not considered modified and they continue to advance through delinquency status and accrue interest according to their original terms. At September 30, 2011, loans with a recorded investment of $642 million were in trial payment programs, of which $301 million were accruing loans and $341 million were nonaccruing loans. No concession is granted during the trial payment period other than an insignificant delay in payments due under the original terms. Our recent experience is that most of the mortgages that enter a trial payment period program are successful in completing the program requirements and are then permanently modified and classified as TDRs at the end of the trial period. As previously discussed, our allowance process considers the impact of those modifications that are probable to occur including the associated credit cost and related re-default risk.
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Purchased Credit-Impaired Loans
Substantially all of our PCI loans were acquired from Wachovia on December 31, 2008. The following table presents PCI loans net of any remaining purchase accounting adjustments.
Total PCI loans (carrying value)
Total PCI loans (unpaid principal balance)
ACCRETABLE YIELD The excess of cash flows expected to be collected over the carrying value of PCI loans is referred to as the accretable yield and is recognized in interest income using an effective yield method over the remaining life of the loan, or pools of loans. The accretable yield is affected by:
Changes in interest rate indices for variable rate PCI loans - Expected future cash flows are based on the variable rates in effect at the time of the regular evaluations of cash flows expected to be collected;
Changes in prepayment assumptions - Prepayments affect the estimated life of PCI loans which may change the amount of interest income, and possibly principal, expected to be collected; and
Changes in the expected principal and interest payments over the estimated life - Updates to expected cash flows are driven by the credit outlook and actions taken with borrowers. Changes in expected future cash flows from loan modifications are included in the regular evaluations of cash flows expected to be collected.
The change in the accretable yield related to PCI loans is presented in the following table.
Total, beginning of period
Accretion into interest income (1)
Accretion into noninterest income due to sales (2)
Reclassification from nonaccretable difference for loans with improving credit-related cash flows
Changes in expected cash flows that do not affect nonaccretable difference (3)
Total, end of period
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PCI ALLOWANCE Based on our regular evaluation of estimates of cash flows expected to be collected, we may establish an allowance for a PCI loan or pool of loans, with a charge to
income though the provision for losses. The following table summarizes the changes in allowance for PCI loan losses.
Balance, December 31, 2008
Provision for losses due to credit deterioration
Charge-offs
Balance, December 31, 2009
Balance, December 31, 2010
Balance, September 30, 2011
Balance, June 30, 2011
COMMERCIAL PCI CREDIT QUALITY INDICATORS The following table provides a breakdown of commercial PCI loans by risk category.
Real
estateconstruction
Total commercial PCI loans
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The following table provides past due information for commercial PCI loans.
CONSUMER PCI CREDIT QUALITY INDICATORSOur consumer PCI loans were aggregated into several pools of loans at acquisition. Below, we have provided credit quality indicators based on the individual loans included in the pool, but we have
not allocated the remaining purchase accounting adjustments, which were established at a pool level. The following table provides the delinquency status of consumer PCI loans.
Total consumer PCI loans
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The following table provides FICO scores for consumer PCI loans.
1-4 family
first
mortgage
By FICO:
The following table shows the distribution of consumer PCI loans by LTV for real estate 1-4 family first mortgages and byCLTV for real estate 1-4 family junior lien mortgages.
Real estate1-4 family
mortgageby LTV
100.01-120% (1)
> 120% (1)
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Note 6: Other Assets
The components of other assets were:
Cost method:
Private equity investments
Total cost method
Principal investments (1)
Total nonmarketable equity investments
Corporate/bank-owned life insurance
Accounts receivable
Interest receivable
Core deposit intangibles
Customer relationship and other amortized intangibles
Government insured/guaranteed (2)
Non-government insured/guaranteed
Operating lease assets
Due from customers on acceptances
Total other assets
Income related to nonmarketable investments was:
Net gains (losses) from:
All other nonmarketable equity investments
Net gains (losses) from nonmarketable equity investments
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Note 7: Securitizations and Variable Interest Entities
Involvement with SPEs
In the normal course of business, we enter into various types of on- and off-balance sheet transactions with special purpose entities (SPEs), which are corporations, trusts or partnerships that are established for a limited purpose. Historically, the majority of SPEs were formed in connection with securitization transactions. In a securitization transaction, assets from our balance sheet are transferred to an SPE, which then issues to investors various forms of interests in those assets and may also enter into derivative transactions. In a securitization transaction, we typically receive cash and/or other interests in an SPE as proceeds for the assets we transfer. Also, in certain transactions, we may retain the right to service the transferred receivables and to repurchase those receivables from the SPE if the outstanding balance of the receivables falls to a level where the cost exceeds the benefits of servicing such receivables. In addition, we may purchase the right to service loans in an SPE that were transferred to the SPE by a third party.
In connection with our securitization activities, we have various forms of ongoing involvement with SPEs, which may include:
underwriting securities issued by SPEs and subsequently making markets in those securities;
providing liquidity facilities to support short-term obligations of SPEs issued to third party investors;
providing credit enhancement on securities issued by SPEs or market value guarantees of assets held by SPEs through the use of letters of credit, financial guarantees, credit default swaps and total return swaps;
entering into other derivative contracts with SPEs;
holding senior or subordinated interests in SPEs;
acting as servicer or investment manager for SPEs; and
providing administrative or trustee services to SPEs.
SPEs are generally considered variable interest entities (VIEs). A VIE is an entity that has either a total equity investment that is insufficient to finance its activities without additional subordinated financial support or whose equity investors lack the ability to control the entity’s activities. A VIE is consolidated by its primary beneficiary, the party that has both the power to direct the activities that most significantly impact the VIE and a variable interest that could potentially be significant to the VIE. A variable interest is a contractual, ownership or other interest that changes with changes in the fair value of the VIE’s net assets. To determine whether or not a variable interest we hold could potentially be significant to the VIE, we consider both qualitative and quantitative factors regarding the nature, size and form of our involvement with the VIE. We assess whether or not we are the primary beneficiary of a VIE on an on-going basis.
We have segregated our involvement with VIEs between those VIEs which we consolidate, those which we do not consolidate and transfers of financial assets that are accounted for as secured borrowings. Secured borrowings are transactions involving transfers of our financial assets to third parties that are accounted for as financings with the assets pledged as collateral. Accordingly, the transferred assets remain recognized on our balance sheet. Subsequent tables within this Note further segregate these transactions by structure type.
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The classifications of assets and liabilities in our balance sheet associated with our transactions with VIEs follow:
VIEs that we
do not
consolidate
VIEs
that we
Transfers that
we account
for as secured
borrowings
Cash
Securities available for sale (1)
Mortgage servicing rights
Total liabilities
Net assets
Mortgages held for sale (2)
Other assets (2)
Accrued expenses and other liabilities (2)
Noncontrolling interests (2)
Transactions with Unconsolidated VIEs
Our transactions with VIEs include securitizations of consumer loans, CRE loans, student loans and auto loans; investment and financing activities involving CDOs backed by asset-backed and CRE securities, collateralized loan obligations (CLOs) backed by corporate loans, and other types of structured financing. We have various forms of involvement with VIEs, including holding senior or subordinated interests, entering into liquidity arrangements, credit default swaps and other derivative contracts. These involvements with unconsolidated VIEs are recorded on our balance sheet primarily in trading assets, securities available for sale, loans, MSRs, other assets and other liabilities, as appropriate.
The following tables provide a summary of unconsolidated VIEs with which we have significant continuing involvement, but we are not the primary beneficiary. We do not consider our continuing involvement in an unconsolidated VIE to be significant when it relates to third-party sponsored VIEs for which we were not the transferor or if we were the sponsor but do not have any other significant continuing involvement.
Significant continuing involvement includes transactions where we were the sponsor or transferor and have other significant forms of involvement. Sponsorship includes transactions with unconsolidated VIEs where we solely or materially participated in the initial design or structuring of the entity or marketing of the transaction to investors. When we transfer assets to a VIE and account for the transfer as a sale, we are considered the transferor. We consider investments in securities held outside of trading, loans, guarantees, liquidity
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Note 7: Securitizations and Variable Interest Entities (continued)
agreements, written options and servicing of collateral to be other forms of involvement that may be significant. We have excluded certain transactions with unconsolidated VIEs from the balances presented in the table below where we have determined
that our continuing involvement is not significant due to the temporary nature and size of our variable interests, because we were not the transferor or because we were not involved in the design or operations of the unconsolidated VIEs.
(in millions)
VIE
assets
Debt and
equity
interests (1)
Servicing
Derivatives
commitments
and
guarantees
Net
Residential mortgage loan securitizations:
Conforming
Other/nonconforming
Commercial mortgage loan securitizations
Collateralized debt obligations:
Debt securities
Loans (2)
Asset-based finance structures
Tax credit structures
Collateralized loan obligations
Investment funds
Other (3)
(continued on following page)
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(continued from previous page)
6,556
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In the two preceding tables, “Total VIE assets” represents the remaining principal balance of assets held by unconsolidated VIEs using the most current information available. For VIEs that obtain exposure to assets synthetically through derivative instruments, the remaining notional amount of the derivative is included in the asset balance. “Carrying value” is the amount in our consolidated balance sheet related to our involvement with the unconsolidated VIEs. “Maximum exposure to loss” from our involvement with off-balance sheet entities, which is a required disclosure under GAAP, is determined as the carrying value of our involvement with off-balance sheet (unconsolidated) VIEs plus the remaining undrawn liquidity and lending commitments, the notional amount of net written derivative contracts, and generally the notional amount of, or stressed loss estimate for, other commitments and guarantees. It represents estimated loss that would be incurred under severe, hypothetical circumstances, for which we believe the possibility is extremely remote, such as where the value of our interests and any associated collateral declines to zero, without any consideration of recovery or offset from any economic hedges. Accordingly, this required disclosure is not an indication of expected loss.
RESIDENTIAL MORTGAGE LOANS Residential mortgage loan securitizations are financed through the issuance of fixed- or floating-rate-asset-backed-securities, which are collateralized by the loans transferred to a VIE. We typically transfer loans we originated to these VIEs, account for the transfers as sales, retain the right to service the loans and may hold other beneficial interests issued by the VIEs. We also may be exposed to limited liability related to recourse agreements and repurchase agreements we make to our issuers and purchasers, which are included in other commitments and guarantees. In certain instances, we may service residential mortgage loan securitizations structured by third parties whose loans we did not originate or transfer. Our residential mortgage loan securitizations consist of conforming and nonconforming securitizations.
Conforming residential mortgage loan securitizations are those that are guaranteed by GSEs, including GNMA. We do not consolidate our conforming residential mortgage loan securitizations because we do not have power over the VIEs.
The loans sold to the VIEs in nonconforming residential mortgage loan securitizations are those that do not qualify for a GSE guarantee. We may hold variable interests issued by the VIEs, primarily in the form of senior securities. We do not consolidate the nonconforming residential mortgage loan securitizations included in the table because we either do not hold any variable interests, hold variable interests that we do not consider potentially significant or are not the primary servicer for a majority of the VIE assets.
Other commitments and guarantees include amounts related to loans sold that we may be required to repurchase, or otherwise indemnify or reimburse the investor or insurer for losses incurred, due to material breach of contractual representations and warranties. The maximum exposure to loss for material breach of contractual representations and warranties represents a stressed case estimate we utilize for
determining stressed case regulatory capital needs and is considered to be a remote scenario.
COMMERCIAL MORTGAGE LOAN SECURITIZATIONS Commercial mortgage loan securitizations are financed through the issuance of fixed- or floating-rate-asset-backed-securities, which are collateralized by the loans transferred to the VIE. In a typical securitization, we may transfer loans we originate to these VIEs, account for the transfers as sales, retain the right to service the loans and may hold other beneficial interests issued by the VIEs. In certain instances, we may service commercial mortgage loan securitizations structured by third parties whose loans we did not originate or transfer. We typically serve as primary or master servicer of these VIEs. The primary or master servicer in a commercial mortgage loan securitization typically cannot make the most significant decisions impacting the performance of the VIE and therefore does not have power over the VIE. We do not consolidate the commercial mortgage loan securitizations included in the disclosure because we either do not have power or do not have a variable interest that could potentially be significant to the VIE.
COLLATERALIZED DEBT OBLIGATIONS (CDOs) A CDO is a securitization where an SPE purchases a pool of assets consisting of asset-backed securities and issues multiple tranches of equity or notes to investors. In some transactions, a portion of the assets are obtained synthetically through the use of derivatives such as credit default swaps or total return swaps.
Prior to 2008, we engaged in the structuring of CDOs on behalf of third party asset managers who would select and manage the assets for the CDO. Typically, the asset manager has some discretion to manage the sale of assets of, or derivatives used by the CDO, which generally gives the asset manager the power over the CDO. We have not structured these types of transactions since the credit market disruption began in late 2007.
In addition to our role as arranger we may have other forms of involvement with these transactions, including transactions established prior to 2008. Such involvement may include acting as liquidity provider, derivative counterparty, secondary market maker or investor. For certain transactions, we may also act as the collateral manager or servicer. We receive fees in connection with our role as collateral manager or servicer.
We assess whether we are the primary beneficiary of CDOs based on our role in the transaction in combination with the variable interests we hold. Subsequently, we monitor our ongoing involvement in these transactions to determine if the nature of our involvement has changed. We are not the primary beneficiary of these transactions in most cases because we do not act as the collateral manager or servicer, which generally denotes power. In cases where we are the collateral manager or servicer, we are not the primary beneficiary because we do not hold interests that could potentially be significant to the VIE.
During third quarter 2011, we incurred a $377 million loss on trading derivatives related to certain CDOs. The loss was associated with the resolution of a legacy Wachovia position that settled in October 2011.
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COLLATERALIZED LOAN OBLIGATIONS (CLOs) A CLO is a securitization where an SPE purchases a pool of assets consisting of loans and issues multiple tranches of equity or notes to investors. Generally, CLOs are structured on behalf of a third party asset manager that typically selects and manages the assets for the term of the CLO. Typically, the asset manager has the power over the significant decisions of the VIE through its discretion to manage the assets of the CLO. We assess whether we are the primary beneficiary of CLOs based on our role in the transaction and the variable interests we hold. In most cases, we are not the primary beneficiary of these transactions because we do not have the power to manage the collateral in the VIE.
In addition to our role as arranger, we may have other forms of involvement with these transactions. Such involvement may include acting as underwriter, derivative counterparty, secondary market maker or investor. For certain transactions, we may also act as the servicer, for which we receive fees in connection with that role. We also earn fees for arranging these transactions and distributing the securities.
ASSET-BASED FINANCE STRUCTURES We engage in various forms of structured finance arrangements with VIEs that are collateralized by various asset classes including energy contracts, auto and other transportation leases, intellectual property, equipment and general corporate credit. We typically provide senior financing, and may act as an interest rate swap or commodity derivative counterparty when necessary. In most cases, we are not the primary beneficiary of these structures because we do not have power over the significant activities of the VIEs involved in these transactions.
For example, we have investments in asset-backed securities that are collateralized by auto leases or loans and cash reserves. These fixed-rate and variable-rate securities have been structured as single-tranche, fully amortizing, unrated bonds that are equivalent to investment-grade securities due to their significant overcollateralization. The securities are issued by VIEs that have been formed by third party auto financing institutions primarily because they require a source of liquidity to fund ongoing vehicle sales operations. The third party auto financing institutions manage the collateral in the VIEs, which is indicative of power in these transactions and we therefore do not consolidate these VIEs.
TAX CREDIT STRUCTURES We co-sponsor and make investments in affordable housing and sustainable energy projects that are designed to generate a return primarily through the realization of federal tax credits. In some instances, our investments in these structures may require that we fund future capital commitments at the discretion of the project sponsors. While the size of our investment in a single entity may at times exceed 50% of the outstanding equity interests, we do not consolidate these structures due to the project sponsor’s ability to manage the projects, which is indicative of power in these transactions.
INVESTMENT FUNDS We do not consolidate the investment funds because we do not absorb the majority of the expected
future variability associated with the funds’ assets, including variability associated with credit, interest rate and liquidity risks.
During third quarter 2011, we redeemed a $1.4 billion interest in an unconsolidated investment fund managed by one of our majority owned subsidiaries, which resulted in a gain of $271 million. Upon redemption we placed the assets received into new investment fund VIEs. We consolidate these new VIEs because we have discretion over the management of the assets and are the sole investor in these funds. At December 31, 2010, we had investments of $1.4 billion and lending arrangements of $14 million with this fund.
OTHER TRANSACTIONS WITH VIEs In August 2008, legacy Wachovia reached an agreement to purchase at par auction rate securities (ARS) that were sold to third-party investors by certain of its subsidiaries. ARS are debt instruments with long-term maturities, but which re-price more frequently, and preferred equities with no maturity. All remaining ARS issued by VIEs subject to the agreement were redeemed. At September 30, 2011, we held in our securities available-for-sale portfolio $668 million of ARS issued by VIEs redeemed pursuant to this agreement, compared with $1.6 billion at December 31, 2010.
On November 18, 2009, we reached agreements to purchase additional ARS from eligible investors who bought ARS through one of our broker-dealer subsidiaries. All remaining ARS issued by VIEs subject to the agreement were redeemed. As of September 30, 2011, we held in our securities available-for-sale portfolio $625 million of ARS issued by VIEs redeemed pursuant to this agreement, compared with $901 million at December 31, 2010.
We do not consolidate the VIEs that issued the ARS because we do not have power over the activities of the VIEs.
TRUST PREFERRED SECURITIES In addition to the involvements disclosed in the preceding table, through the issuance of trust preferred securities we had junior subordinated debt financing with a carrying value of $13.5 billion at September 30, 2011, and $19.3 billion at December 31, 2010, and $2.5 billion of preferred stock at September 30, 2011. In these transactions, VIEs that we wholly own issue debt securities or preferred equity to third party investors. All of the proceeds of the issuance are invested in debt securities or preferred equity that we issue to the VIEs. The VIEs’ operations and cash flows relate only to the issuance, administration and repayment of the securities held by third parties. We do not consolidate these VIEs because the sole assets of the VIEs are receivables from us. This is the case even though we own all of the voting equity shares of the VIEs, have fully guaranteed the obligations of the VIEs and may have the right to redeem the third party securities under certain circumstances. We report the debt securities issued to the VIEs as long-term junior subordinated debt and the preferred equity securities issued to the VIEs as preferred stock in our consolidated balance sheet.
In the first nine months of 2011, we called $9.2 billion of trust preferred securities that will no longer count as Tier 1 capital under the Dodd-Frank Act and the Basel Committee recommendations known as the Basel III standards. Of the $9.2
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billion of trust preferred securities, $5.8 billion settled in October 2011.
Securitization Activity Related to Unconsolidated VIEs
We use VIEs to securitize consumer and CRE loans and other types of financial assets, including student loans and auto loans. We typically retain the servicing rights from these sales and may continue to hold other beneficial interests in the VIEs. We may also provide liquidity to investors in the beneficial interests and credit enhancements in the form of standby letters of credit. Through these securitizations we may be exposed to liability
under limited amounts of recourse as well as standard representations and warranties we make to purchasers and issuers.
We recognized net gains of $39 million and $105 million from transfers accounted for as sales of financial assets in securitizations in the third quarter and first nine months of 2011, respectively, and net gains of $2 million and $10 million, respectively, in the same periods of 2010. Additionally, we had the following cash flows with our securitization trusts that were involved in transfers accounted for as sales.
Sales proceeds from securitizations (1)
Servicing fees
Other interests held
Purchases of delinquent assets
Net servicing advances
Sales with continuing involvement during the third quarter and first nine months of 2011 and 2010 predominantly related to conforming residential mortgage securitizations. During the third quarter and first nine months of 2011 we transferred $73.1 billion and $245.4 billion, respectively, in fair value of conforming residential mortgages to unconsolidated VIEs and recorded the transfers as sales, compared with $97.8 billion and $263.5 billion, respectively, in the same periods of 2010. These transfers did not result in a gain or loss because the loans are
already carried at fair value. In connection with these transfers, in the first nine months of 2011 we recorded a $2.7 billion servicing asset, measured at fair value using a Level 3 measurement technique, and a $74 million liability for repurchase reserves, compared with a $3.0 billion servicing asset and a $109 million liability in the first nine months of 2010.
We used the following key assumptions to measure mortgage servicing assets at the date of securitization:
Prepayment speed (annual CPR (1))
Life (in years)
Discount rate
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Key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at September 30, 2011, for residential and commercial mortgage servicing rights, and other interests held related primarily to residential mortgage loan securitizations are presented in the following table. In the following table “Other interests held” exclude securities retained in securitizations issued through GSEs such as FNMA, FHLMC and GNMA because we do not
believe the value of these securities would be materially affected by the adverse changes in assumptions noted in the table. Subordinated interests include only those bonds whose credit rating was below AAA by a major rating agency at issuance. Senior interests include only those bonds whose credit rating was AAA by a major rating agency at issuance. The information presented excludes trading positions held in inventory.
Fair value of interests held at September 30, 2011
Expected weighted-average life (in years)
Prepayment speed assumption (annual CPR)
Decrease in fair value from:
10% adverse change
25% adverse change
Discount rate assumption
100 basis point increase
200 basis point increase
Credit loss assumption
10% higher losses
25% higher losses
Fair value of interests held at December 31, 2010
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The sensitivities in the preceding table are hypothetical and caution should be exercised when relying on this data. Changes in value based on variations in assumptions generally cannot be extrapolated because the relationship of the change in the assumption to the change in value may not be linear. Also, the effect of a variation in a particular assumption on the value of the other interests held is calculated independently without changing any other assumptions. In reality, changes in one factor may result in changes in others (for example, changes in prepayment speed estimates could result in changes in the credit losses), which might magnify or counteract the sensitivities.
The following table presents information about the principal balances of off-balance sheet securitized loans, including
residential mortgages sold to FNMA, FHLMC, GNMA and securitizations where servicing is our only form of continuing involvement. Delinquent loans include loans 90 days or more past due and still accruing interest as well as nonaccrual loans. In securitizations where servicing is our only form of continuing involvement, we would only experience a loss if required to repurchase a delinquent loan due to a breach in representations and warranties associated with our loan sale or servicing contracts. Net charge-offs exclude loans sold to FNMA, FHLMC and GNMA as we do not service or manage the underlying real estate upon foreclosure and, as such, do not have access to net charge-off information.
Total off-balance sheet securitized loans
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Transactions with Consolidated VIEs and Secured Borrowings
The following table presents a summary of transfers of financial assets accounted for as secured borrowings and involvements with consolidated VIEs. “Consolidated assets” are presented using GAAP measurement methods, which may include fair
value, credit impairment or other adjustments, and therefore in some instances will differ from “Total VIE assets.” On the consolidated balance sheet, we separately disclose the consolidated assets of certain VIEs that can only be used to settle the liabilities of those VIEs.
Secured borrowings:
Municipal tender option bond securitizations
Commercial real estate loans
Residential mortgage securitizations
Total secured borrowings
Consolidated VIEs:
Nonconforming residential mortgage loan securitizations
Multi-seller commercial paper conduit
Auto loan securitizations
Structured asset finance
Total consolidated VIEs
Total secured borrowings and consolidated VIEs
In addition to the transactions included in the table above, at September 30, 2011, we had issued approximately $6.0 billion of private placement debt financing through a consolidated VIE. The issuance is classified as long-term debt in our consolidated financial statements. At September 30, 2011, we had pledged approximately $6.4 billion in loans (principal and interest eligible to be capitalized), $331 million in securities available for sale and $50 million in cash and cash equivalents to collateralize the VIE’s borrowings. Such assets were not transferred to the VIE and accordingly we have excluded the VIE from the previous table.
We have raised financing through the securitization of certain financial assets in transactions with VIEs accounted for as secured borrowings. We also consolidate VIEs where we are the primary beneficiary. In certain transactions other than the multi-seller commercial paper conduit, we provide contractual support in the form of limited recourse and liquidity to facilitate the remarketing of short-term securities issued to third party investors. Other than this limited contractual support, the assets of the VIEs are the sole source of repayment of the securities held by third parties. The liquidity support we provide to the multi-seller commercial paper conduit ensures timely repayment
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of commercial paper issued by the conduit and is described further below.
NONCONFORMING RESIDENTIAL MORTGAGE LOAN SECURITIZATIONS We have consolidated certain of our nonconforming residential mortgage loan securitizations in accordance with consolidation accounting guidance. We have determined we are the primary beneficiary of these securitizations because we have the power to direct the most significant activities of the entity through our role as primary servicer and also hold variable interests that we have determined to be significant. The nature of our variable interests in these entities may include beneficial interests issued by the VIE, mortgage servicing rights and recourse or repurchase reserve liabilities. The beneficial interests issued by the VIE that we hold include either subordinate or senior securities held in an amount that we consider potentially significant.
MULTI-SELLER COMMERCIAL PAPER CONDUIT We administer a multi-seller asset-based commercial paper conduit that finances certain client transactions. This conduit is a bankruptcy remote entity that makes loans to, or purchases certificated interests, generally from SPEs, established by our clients (sellers) and which are secured by pools of financial assets. The conduit funds itself through the issuance of highly rated commercial paper to third party investors. The primary source of repayment of the commercial paper is the cash flows from the conduit’s assets or the re-issuance of commercial paper upon maturity. The conduit’s assets are structured with deal-specific credit enhancements generally in the form of overcollateralization provided by the seller, but may also include subordinated interests, cash reserve accounts, third party credit support facilities and excess spread capture. The timely repayment of the commercial paper is further supported by asset-specific liquidity facilities in the form of liquidity asset purchase agreements that we provide. Each facility is equal to 102% of the conduit’s funding commitment to a client. The aggregate amount of liquidity must be equal to or greater than all the commercial paper issued by the conduit. At the discretion of the administrator, we may be required to purchase assets from the conduit at par value plus accrued interest or discount on the related commercial paper, including situations where the conduit is unable to issue commercial paper. Par value may be different from fair value.
We receive fees in connection with our role as administrator and liquidity provider. We may also receive fees related to the structuring of the conduit’s transactions. In 2010, the conduit terminated its subordinated note to a third party investor and repaid all amounts due under the terms of the note agreement. We are the primary beneficiary of the conduit because we have power over the significant activities of the conduit and have a significant variable interest due to our liquidity arrangement.
INVESTMENT FUNDSWe have consolidated certain of our investment funds where we manage the assets of the fund and our interests absorb a majority of the funds’ variability. In third quarter 2011, we redeemed our interest in an unconsolidated investment fund and placed the assets received upon redemption
into new VIEs. We consolidate these VIEs because we have discretion over the management of the assets and are the sole investor in these funds.
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Note 8: Mortgage Banking Activities
Mortgage banking activities, included in the Community Banking and Wholesale Banking operating segments, consist of residential and commercial mortgage originations and servicing.
We apply the fair value method to substantially all of our residential MSRs and apply the amortization method to all commercial and some residential MSRs. The changes in MSRs measured using the fair value method were:
Fair value, beginning of period
Adjustments from adoption of consolidation accounting guidance
Servicing from securitizations or asset transfers
Net additions
Changes in fair value:
Due to changes in valuation model inputs or assumptions (1)
Other changes in fair value (2)
Total changes in fair value
Fair value, end of period
The changes in amortized MSRs were:
Amortization
Balance, end of period (1)
Valuation allowance:
Provision for MSRs in excess of fair value
Balance, end of period (2)
Amortized MSRs, net
Fair value of amortized MSRs:
Beginning of period
End of period (3)
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Note 8: Mortgage Banking Activities(continued)
We present the components of our managed servicing portfolio in the following table at unpaid principal balance for
loans serviced and subserviced for others and at book value for owned loans serviced.
Residential mortgage servicing:
Serviced for others
Owned loans serviced
Subservicing
Total residential servicing
Commercial mortgage servicing:
Total commercial servicing
Total managed servicing portfolio
Total serviced for others
Ratio of MSRs to related loans serviced for others
The components of mortgage banking noninterest income were:
Servicing income, net:
Servicing fees:
Contractually specified servicing fees
Late charges
Ancillary fees
Unreimbursed direct servicing costs (1)
Net servicing fees
Changes in fair value of MSRs carried at fair value:
Due to changes in valuation model inputs or assumptions (2)
Other changes in fair value (3)
Total changes in fair value of MSRs carried at fair value
Net derivative gains from economic hedges (4)
Total servicing income, net
Total mortgage banking noninterest income
Market-related valuation changes to MSRs, net of hedge results (2) + (4)
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The table below summarizes the changes in our liability for mortgage loan repurchase losses. This liability is in “Accrued expenses and other liabilities” in our consolidated financial statements and the provision for repurchase losses reduces net gains on mortgage loan origination/sales activities. Because the level of mortgage loan repurchase losses depends upon economic factors, investor demand strategies and other external conditions that may change over the life of the underlying loans, the level of the liability for mortgage loan repurchase losses is difficult to estimate and requires considerable management judgment. We maintain regular contact with the GSEs and other significant investors to monitor and address their repurchase demand practices and concerns. Because of the uncertainty in the various estimates underlying the mortgage repurchase liability, there is a range of losses in excess of the recorded mortgage repurchase liability that are reasonably possible. The estimate of the range of possible loss for representations and warranties does not represent a probable loss, and is based on currently available information, significant judgment, and a number of assumptions that are subject to change. The high end of this range of reasonably possible losses in excess of our recorded liability was $1.9 billion at September 30, 2011, and was determined based upon modifying the assumptions utilized in our best estimate of probable loss to reflect what we believe to be the high end of reasonably possible adverse assumptions.
Change in estimate – primarily due to credit deterioration
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Note 9: Intangible Assets
The gross carrying value of intangible assets and accumulated amortization was:
Amortized intangible assets (1):
MSRs (2)
Customer relationship and other intangibles
Total amortized intangible assets
Unamortized intangible assets:
MSRs (carried at fair value) (2)
Trademark
We based our projections of amortization expense shown below on existing asset balances at September 30, 2011. Future amortization expense may vary from these projections.
The following table provides the current year and estimated future amortization expense for amortized intangible assets.
Nine months ended September 30, 2011 (actual)
Estimate for the remainder of 2011
Estimate for year ended December 31,
2012
2013
2014
2015
2016
For our goodwill impairment analysis, we allocate all of the goodwill to the individual operating segments. We identify reporting units that are one level below an operating segment (referred to as a component), and distinguish these reporting units based on how the segments and components are managed, taking into consideration the economic characteristics, nature of
the products and customers of the components. We allocate goodwill to reporting units based on relative fair value, using certain performance metrics. See Note 17 for further information on management reporting.
The following table shows the allocation of goodwill to our operating segments for purposes of goodwill impairment testing.
December 31, 2009
Goodwill from business combinations
September 30, 2010
Reduction in goodwill related to divested businesses
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Note 10: Guarantees, Pledged Assets and Collateral
Guarantees are contracts that contingently require us to make payments to a guaranteed party based on an event or a change in an underlying asset, liability, rate or index. Guarantees are generally in the form of standby letters of credit, securities lending and other indemnifications, liquidity agreements,
written put options, recourse obligations, residual value guarantees, and contingent consideration. The following table shows carrying value, maximum exposure to loss on our guarantees and the amount with a higher risk of performance.
Standby letters of credit
Securities lending and other indemnifications
Liquidity agreements (1)
Written put options (1)(2)
Loans and MHFS sold with recourse
Residual value guarantees
Contingent consideration
Other guarantees
Total guarantees
(1) Certain of these agreements included in this table are related to off-balance sheet entities and, accordingly, are also disclosed in Note 7.
(2) Written put options, which are in the form of derivatives, are also included in the derivative disclosures in Note 12.
“Maximum exposure to loss” and “Non-investment grade” are required disclosures under GAAP. Non-investment grade represents those guarantees on which we have a higher risk of being required to perform under the terms of the guarantee. If the underlying assets under the guarantee are non-investment grade (that is, an external rating that is below investment grade or an internal credit default grade that is equivalent to a below investment grade external rating), we consider the risk of performance to be high. Internal credit default grades are determined based upon the same credit policies that we use to evaluate the risk of payment or performance when making loans and other extensions of credit. These credit policies are further described in Note 5.
Maximum exposure to loss represents the estimated loss that would be incurred under an assumed hypothetical circumstance, despite what we believe is its extremely remote possibility, where the value of our interests and any associated collateral declines to zero, without any consideration of recovery or offset from any economic hedges. Accordingly, this required disclosure is not an indication of expected loss. We believe the carrying value, which is either fair value for derivative related products or the allowance for lending related commitments, is more representative of our exposure to loss than maximum exposure to loss.
STANDBY LETTERS OF CREDIT We issue standby letters of credit, which include performance and financial guarantees, for customers in connection with contracts between our customers and third parties. Standby letters of credit are agreements where we are obligated to make payment to a third party on behalf of a customer in the event the customer fails to meet their contractual obligations. We consider the credit risk in standby letters of credit and commercial and similar letters of credit in determining the allowance for credit losses.
SECURITIES LENDING AND OTHER INDEMNIFICATIONS As a securities lending agent, we lend securities from participating institutional clients’ portfolios to third-party borrowers. We indemnify our clients against default by the borrower in returning these lent securities. This indemnity is supported by collateral received from the borrowers. Collateral is generally in the form of cash or highly liquid securities that are marked to market daily. There was $3.8 billion at September 30, 2011, and $14.0 billion at December 31, 2010, in collateral supporting loaned securities with values of $3.7 billion and $13.6 billion, respectively.
We enter into other types of indemnification agreements in the ordinary course of business under which we agree to indemnify third parties against any damages, losses and expenses incurred in connection with legal and other proceedings arising from relationships or transactions with us. These relationships or transactions include those arising from service as a director or officer of the Company, underwriting agreements relating to our securities, acquisition agreements and various other business transactions or arrangements. Because the extent of our obligations under these agreements depends entirely upon the occurrence of future events, we are unable to determine our potential future liability under these agreements. We do, however, record a liability for residential mortgage loans that we may have to repurchase pursuant to various representations and warranties. See Note 8 for additional information on the liability for mortgage loan repurchase losses.
LIQUIDITY AGREEMENTS We provide liquidity facilities on all commercial paper issued by the conduit we administer. We also provide liquidity to certain off-balance sheet entities that hold securitized fixed-rate municipal bonds and consumer or
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Note 10: Guarantees, Pledged Assets and Collateral (continued)
commercial assets that are partially funded with the issuance of money market and other short-term notes. See Note 7 for additional information on these arrangements.
WRITTEN PUT OPTIONS Written put options are contracts that give the counterparty the right to sell to us an underlying instrument held by the counterparty at a specified price, and include options, floors, caps and credit default swaps. These written put option contracts generally permit net settlement. While these derivative transactions expose us to risk in the event the option is exercised, we manage this risk by entering into offsetting trades or by taking short positions in the underlying instrument. We offset substantially all put options written to customers with purchased options. Additionally, for certain of these contracts, we require the counterparty to pledge the underlying instrument as collateral for the transaction. Our ultimate obligation under written put options is based on future market conditions and is only quantifiable at settlement. See Note 7 for additional information regarding transactions with VIEs and Note 12 for additional information regarding written derivative contracts.
LOANS AND MHFS SOLD WITH RECOURSE In certain loan sales or securitizations, we provide recourse whereby we are required to indemnify the buyer for any loss on the loan up to par value plus accrued interest. We provide recourse, predominantly to the GSEs, on loans sold under various programs and arrangements. Primarily all of these programs and arrangements require that we share in the loans’ credit exposure for their remaining life by providing recourse to the GSE in the event of borrower default, up to 33.33% of actual losses incurred on a pro-rata basis. Under the remaining recourse programs and arrangements, if certain events occur within a specified period of time from transfer date, we have to provide limited recourse to the buyer to indemnify them for losses incurred for the remaining life of the loans. The maximum exposure to loss reported in the accompanying table represents the outstanding principal balance of the loans sold or securitized that are subject to recourse provisions or the maximum losses per the contractual agreements. However, we believe, the likelihood of loss of the entire balance due to these recourse agreements is remote and amounts paid can be recovered in whole or in part from the sale of collateral. In third quarter 2011, we repurchased $11 million of loans associated with these agreements. We also provide representation and warranty guarantees on loans sold under the various recourse programs and arrangements. Our loss exposure relative to these guarantees is separately considered and provided for, as necessary, in determination of our liability for loan repurchases due to breaches of representations and warranties. See Note 8 for additional information on the liability for mortgage loan repurchase losses.
RESIDUAL VALUE GUARANTEES We have provided residual value guarantees as part of certain leasing transactions of corporate assets. At September 30, 2011, the only remaining residual value guarantee is related to a leasing transaction on certain corporate buildings. The lessors in these leases are
generally large financial institutions or their leasing subsidiaries. These guarantees protect the lessor from loss on sale of the related asset at the end of the lease term. To the extent that a sale of the leased assets results in proceeds less than a stated percent (generally 80% to 89%) of the asset’s cost, we would be required to reimburse the lessor under our guarantee.
CONTINGENT CONSIDERATION In connection with certain brokerage, asset management, insurance agency and other acquisitions we have made, the terms of the acquisition agreements provide for deferred payments or additional consideration, based on certain performance targets.
We have entered into various contingent performance guarantees through credit risk participation arrangements. Under these agreements, if a customer defaults on its obligation to perform under certain credit agreements with third parties, we will be required to make payments to the third parties.
Pledged Assets and Collateral
As part of our liquidity management strategy, we pledge assets to secure trust and public deposits, borrowings from the FHLB and FRB and for other purposes as required or permitted by law. The following table provides pledged loans and securities available for sale where the secured party does not have the right to sell or repledge the collateral. At September 30, 2011, and December 31, 2010, we did not pledge any loans or securities available for sale where the secured party has the right to sell or repledge the collateral. The table excludes pledged assets related to VIEs, which can only be used to settle the liabilities of those entities. See Note 7 for additional information on consolidated VIE assets.
We also pledge certain financial instruments that we own to collateralize repurchase agreements and other securities financings. The types of collateral we pledge include securities issued by federal agencies, government-sponsored entities (GSEs), and domestic and foreign companies. We pledged $25.5 billion at September 30, 2011, and $27.3 billion at December 31, 2010, under agreements that permit the secured parties to sell or repledge the collateral. Pledged collateral where the secured party cannot sell or repledge was $3.8 billion and $5.9 billion at the same period ends, respectively.
We receive collateral from other entities under resale agreements and securities borrowings. We received $21.2 billion at September 30, 2011, and $22.5 billion at December 31, 2010, for which we have the right to sell or repledge the collateral. These amounts include securities we have sold or repledged to others with a fair value of $19.6 billion at September 30, 2011, and $14.6 billion at December 31, 2010.
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Note 11: Legal Actions
The following supplements our discussion of certain matters previously reported in Part I, Item 3 (Legal Proceedings) of our Annual Report on Form 10-K for the year ended December 31, 2010 and in Part II, Item 1 (Legal Proceedings) of our Quarterly Reports on Form 10-Q for the periods ended March 31, 2011 and June 30, 2011.
ELAVON LITIGATION The parties have agreed to settle the case. Payment will occur upon final documentation of the settlement. The settlement was accounted for in prior periods and will not have an adverse effect on the Company’s consolidated financial position.
ERISA LITIGATION The U.S. District Court for the District of Minnesota granted final approval of the $17.5 million settlement in Figas v. Wells Fargo & Company, et al., on August 9, 2011.
The U. S. District Court for the Western District of North Carolina granted final approval of the $12.4 million settlement in In re Wachovia Corporation ERISA Litigation on October 24, 2011.
ILLINOIS ATTORNEY GENERAL LITIGATION On October 26, 2011 the Illinois Court issued an order granting, in part, and denying, in part, Wells Fargo’s motion to dismiss. The Court dismissed Wells Fargo & Company as a party and dismissed Count III of the complaint, which alleged violations of the Illinois Fair Lending Act. The Court denied the remainder of the motion to dismiss.
IN RE WELLS FARGO MORTGAGE-BACKED CERTIFICATES LITIGATION On May 27, 2011, Wells Fargo and the plaintiffs agreed to settle the matter captioned In re Wells Fargo Mortgage-Backed Securities Litigation for $125 million. On July 26, 2011, the Court entered an order preliminarily approving the settlement. The hearing on final approval of the settlement took place on October 27, 2011, and we await the Court’s ruling. Some class members have opted out of the settlement, with the most significant being the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and American International Group, Inc.
On April 20, 2011, a case captioned Federal Home Loan of Boston v. Ally Financial, Inc., et al., was filed in the Superior Court of the Commonwealth of Massachusetts for the County of Suffolk. The case names, among a large number of parties, Wells Fargo & Company, Wells Fargo Asset Securitization Corporation and Wells Fargo Bank, National Association as parties and contains allegations substantially similar to the cases filed by the other Federal Home Loan Banks.
On April 28, 2011, a case captioned The Union Central Life Insurance Company, et al. v. Credit Suisse First Boston Securities Corp., et al., was filed in the U.S. District Court for the Southern District of New York. Among other defendants, it names Wells Fargo Asset Securitization Corporation and Wells Fargo Bank, National Association. The case asserts various state law fraud claims and claims for violations of sections 10(b) and
20(a) of the Securities Exchange Act of 1934 on behalf of three insurance companies, relating to offerings of mortgage-backed securities from 2005 through 2007.
In addition, there are other cases involving other issuers of mortgage-backed certificates where Wells Fargo may have indemnity obligations because the pools of mortgages backing the certificates contain mortgages originated by Wells Fargo.
LE-NATURE’S, INC.The Le-Nature’s cases have settled for the total sum of $95 million. The settlement was accounted for in prior periods and payment did not have an adverse effect on Wells Fargo’s consolidated financial position.
MEDICAL CAPITAL CORPORATION LITIGATION Wells Fargo Bank, N.A. served as indenture trustee for debt issued by affiliates of Medical Capital Corporation, which was placed in receivership at the request of the Securities and Exchange Commission in August 2009. Since September 2009, Wells Fargo has been named as a defendant in various class and mass actions brought by holders of Medical Capital Corporation’s debt, alleging that Wells Fargo breached contractual and other legal obligations owed to them and seeking unspecified damages.
The actions have been consolidated in the United States District Court for the Central District of California. On July 26, 2011, the District Court certified a class consisting of holders of notes issued by affiliates of Medical Capital Corporation and, on October 18, 2011, the Ninth Circuit Court of Appeals denied a petition seeking to appeal the class certification order.
MUNICIPAL DERIVATIVES BID PRACTICES INVESTIGATION The plaintiffs and Wells Fargo agreed to settle the In re Municipal Derivatives Antitrust Litigation on October 21, 2011. The settlement is subject to court approval and, if approved, will result in Wells Fargo paying an amount equal to the greater of $37 million or 65% of the restitution amount of a future settlement, if any, with the various state Attorneys General of their investigation of Wachovia.
OUTLOOK The Company establishes a liability for contingent litigation losses when it determines that a potential loss is both probable and estimable. In addition, for significant matters, the Company determines a range of potential loss that is reasonably possible. The high end of the range of reasonably possible potential litigation losses in excess of the Company’s liability for probable and estimable losses was $1.6 billion as of September 30, 2011. For these matters and others where an unfavorable outcome is reasonably possible but not probable, there may be a range of possible losses in excess of the established liability that cannot be estimated. Based on information currently available, advice of counsel, available insurance coverage and established reserves, Wells Fargo believes that the eventual outcome of the actions against Wells Fargo and/or its subsidiaries, including the matters described above, will not, individually or in the aggregate, have a material adverse effect on Wells Fargo’s consolidated financial position.
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Note 11: Legal Actions (continued)
However, in the event of unexpected future developments, it is possible that the ultimate resolution of those matters, if
unfavorable, may be material to Wells Fargo’s results of operations for any particular period.
Note 12: Derivatives
We use derivatives to manage exposure to market risk, interest rate risk, credit risk and foreign currency risk, to generate profits from proprietary trading and to assist customers with their risk management objectives. Derivative transactions are measured in terms of the notional amount, but this amount is not recorded on the balance sheet and is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments. The notional amount is generally not exchanged, but is used only as the basis on which interest and other payments are determined.
Our asset/liability management approach to interest rate, foreign currency and certain other risks includes the use of derivatives. Such derivatives are typically designated as fair value or cash flow hedges, or economic hedge derivatives for those that do not qualify for hedge accounting. This helps minimize significant, unplanned fluctuations in earnings, fair values of assets and liabilities, and cash flows caused by interest rate, foreign currency and other market value volatility. This approach involves modifying the repricing characteristics of certain assets and liabilities so that changes in interest rates, foreign currency and other exposures do not have a significantly adverse effect on the net interest margin, cash flows and earnings. As a result of fluctuations in these exposures, hedged assets and liabilities will gain or lose market value. In a fair value or economic hedge, the effect of this unrealized gain or loss will generally be offset by the gain or loss on the derivatives linked to the hedged assets and liabilities. In a cash flow hedge, where we manage the variability of cash payments due to interest rate fluctuations by the effective use of derivatives linked to hedged assets and liabilities, the unrealized gain or loss on the derivatives or the hedged asset or liability is generally not reflected in earnings.
We also offer various derivatives, including interest rate, commodity, equity, credit and foreign exchange contracts, to our customers but usually offset our exposure from such contracts by purchasing other financial contracts. The customer accommodations and any offsetting financial contracts are treated as free-standing derivatives. Free-standing derivatives also include derivatives we enter into for risk management that do not otherwise qualify for hedge accounting, including economic hedge derivatives. To a lesser extent, we take positions based on market expectations or to benefit from price differentials between financial instruments and markets. Additionally, free-standing derivatives include embedded derivatives that are required to be accounted for separately from their host contracts.
The following table presents the total notional or contractual amounts and fair values for derivatives designated as qualifying hedge contracts, which are used as asset/liability management hedges, and free-standing derivatives (economic hedges) not designated as hedging instruments that are recorded on the balance sheet in other assets or other liabilities. Customer accommodation, trading and other free-standing derivatives are recorded on the balance sheet at fair value in trading assets or other liabilities.
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Notional orcontractualamount
Qualifying hedge contracts
Interest rate contracts (1)
Foreign exchange contracts
Total derivatives designated as qualifying hedging instruments
Derivatives not designated as hedging instruments
Free-standing derivatives (economic hedges):
Interest rate contracts (2)
Equity contracts
Credit contracts - protection purchased
Other derivatives
Subtotal
Customer accommodation, trading and other free-standing derivatives:
Interest rate contracts
Commodity contracts
Credit contracts - protection sold
Total derivatives not designated as hedging instruments
Total derivatives before netting
Netting (3)
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Note 12: Derivatives (continued)
Fair Value Hedges
We use interest rate swaps to convert certain of our fixed-rate long-term debt and CDs to floating rates to hedge our exposure to interest rate risk. We also enter into cross-currency swaps, cross-currency interest rate swaps and forward contracts to hedge our exposure to foreign currency risk and interest rate risk associated with the issuance of non-U.S. dollar denominated long-term debt. In addition, we use interest rate swaps and forward contracts to hedge against changes in fair value of certain investments in available-for-sale debt securities due to changes in interest rates, foreign currency rates, or both. We also use interest rate swaps to hedge against changes in fair value for certain mortgages held for sale. The entire derivative gain or loss is included in the assessment of hedge effectiveness for all fair value hedge relationships, except for those involving foreign-currency denominated securities available for sale and long-term debt hedged with foreign currency forward derivatives for which
the component of the derivative gain or loss related to the changes in the difference between the spot and forward price is excluded from the assessment of hedge effectiveness.
We use statistical regression analysis to assess hedge effectiveness, both at inception of the hedging relationship and on an ongoing basis. The regression analysis involves regressing the periodic change in fair value of the hedging instrument against the periodic changes in fair value of the asset or liability being hedged due to changes in the hedged risk(s). The assessment includes an evaluation of the quantitative measures of the regression results used to validate the conclusion of high effectiveness.
The following table shows the net gains (losses) recognized in the income statement related to derivatives in fair value hedging relationships.
Total netgains
(losses)on fairvaluehedges
Gains (losses) recorded in net interest income
Gains (losses) recorded in noninterest income
Recognized on derivatives
Recognized on hedged item
Recognized on fair value hedges (ineffective portion) (1)
Quarter ended September 30, 2010
Nine months ended September 30, 2010
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Cash Flow Hedges
We hedge floating-rate debt against future interest rate increases by using interest rate swaps, caps, floors and futures to limit variability of cash flows due to changes in the benchmark interest rate. We also use interest rate swaps and floors to hedge the variability in interest payments received on certain floating-rate commercial loans, due to changes in the benchmark interest rate. Gains and losses on derivatives that are reclassified from cumulative OCI to current period earnings are included in the line item in which the hedged item’s effect on earnings is recorded. All parts of gain or loss on these derivatives are included in the assessment of hedge effectiveness. We assess hedge effectiveness using regression analysis, both at inception of the hedging relationship and on an ongoing basis. The regression analysis involves regressing the periodic
changes in cash flows of the hedging instrument against the periodic changes in cash flows of the forecasted transaction being hedged due to changes in the hedged risk(s). The assessment includes an evaluation of the quantitative measures of the regression results used to validate the conclusion of high effectiveness.
Based upon current interest rates, we estimate that $330 million (pre-tax) of deferred net gains on derivatives in OCI at September 30, 2011, will be reclassified as earnings during the next twelve months. Future changes to interest rates may significantly change actual amounts reclassified to earnings. We are hedging our exposure to the variability of future cash flows for all forecasted transactions for a maximum of 7 years for both hedges of floating-rate debt and floating-rate commercial loans.
The following table shows the net gains (losses) recognized related to derivatives in cash flow hedging relationships.
Gains (losses) (after tax) recognized in OCI on derivatives
Gains (pre tax) reclassified from cumulative OCI into net interest income
Gains (losses) (pre tax) recognized in noninterest income on derivatives (1)
Free-Standing Derivatives
We use free-standing derivatives (economic hedges), in addition to debt securities available for sale, to hedge the risk of changes in the fair value of residential MSRs measured at fair value, certain residential MHFS, derivative loan commitments and other interests held. The resulting gain or loss on these economic hedges is reflected in other income.
The derivatives used to hedge these MSRs measured at fair value, which include swaps, swaptions, constant maturity mortgages, forwards, Eurodollar and Treasury futures and options contracts, resulted in net derivative gains of $3.2 billion and $4.6 billion, respectively, in the third quarter and first nine months of 2011 and net derivative gains of $1.2 billion and $6.2 billion, respectively, in the same periods of 2010, which are included in mortgage banking noninterest income. The aggregate fair value of these derivatives was a net asset of $1.5 billion at September 30, 2011, and a net liability of $943 million at December 31, 2010. Changes in fair value of debt securities available for sale (unrealized gains and losses) are not included in servicing income, but are reported in cumulative OCI (net of tax) or, upon sale, are reported in net gains (losses) on debt securities available for sale.
Interest rate lock commitments for residential mortgage loans that we intend to sell are considered free-standing derivatives. Our interest rate exposure on these derivative loan commitments, as well as substantially all residential MHFS, is hedged with free-standing derivatives (economic hedges) such as swaps, forwards and options, Eurodollar futures and options, and Treasury futures, forwards and options contracts. The commitments, free-standing derivatives and residential MHFS are carried at fair value with changes in fair value included in mortgage banking noninterest income. For the fair value
measurement of interest rate lock commitments we 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. Fair value 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 is affected primarily by changes in interest rates and the passage of time. However, changes in investor demand can also cause changes in the value of the underlying loan value that cannot be hedged. The aggregate fair value of derivative loan commitments in the balance sheet was a net asset of $266 million at September 30, 2011, and a net liability of $271 million at December 31, 2010, and is included in the caption “Interest rate contracts” under “Customer accommodation, trading and other free-standing derivatives” in the first table in this Note.
We also enter into various derivatives primarily to provide derivative products to customers. To a lesser extent, we take positions based on market expectations or to benefit from price differentials between financial instruments and markets. These derivatives are not linked to specific assets and liabilities in the balance sheet or to forecasted transactions in an accounting hedge relationship and, therefore, do not qualify for hedge accounting. We also enter into free-standing derivatives for risk management that do not otherwise qualify for hedge accounting. They are carried at fair value with changes in fair value recorded as other noninterest income.
Free-standing derivatives also include embedded derivatives that are required to be accounted for separately from their host contract. We periodically issue hybrid long-term notes and CDs where the performance of the hybrid instrument notes is linked
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to an equity, commodity or currency index, or basket of such indices. These notes contain explicit terms that affect some or all of the cash flows or the value of the note in a manner similar to a derivative instrument and therefore are considered to contain an “embedded” derivative instrument. The indices on which the performance of the hybrid instrument is calculated are not clearly and closely related to the host debt instrument. The “embedded” derivative is separated from the host contract and accounted for as a free-standing derivative. Additionally, we may
invest in hybrid instruments that contain embedded derivatives, such as credit derivatives, that are not clearly and closely related to the host contract. In such instances, we either elect fair value option for the hybrid instrument or separate the embedded derivative from the host contract and account for the host contract and derivative separately.
The following table shows the net gains recognized in the income statement related to derivatives not designated as hedging instruments.
Gains (losses) recognized on free-standing derivatives(economic hedges):
Recognized in noninterest income:
Foreign exchange contracts (2)
Equity contracts (2)
Credit contracts (2)
Gains (losses) recognized on customer accommodation, tradingand other free-standing derivatives:
Interest rate contracts (3)
Commodity contracts (4)
Equity contracts (4)
Foreign exchange contracts (4)
Credit contracts (4)
Other (4)
Net gains recognized related to derivatives not designated as hedging instruments
Credit Derivatives
We use credit derivatives to manage exposure to credit risk related to lending and investing activity and to assist customers with their risk management objectives. This may include protection sold to offset purchased protection in structured product transactions, as well as liquidity agreements written to special purpose vehicles. The maximum exposure of sold credit derivatives is managed through posted collateral, purchased credit derivatives and similar products in order to achieve our desired credit risk profile. This credit risk management provides an ability to recover a significant portion of any amounts that would be paid under the sold credit derivatives. We would be required to perform under the noted credit derivatives in the event of default by the referenced obligors. Events of default include events such as bankruptcy, capital restructuring or lack of principal and/or interest payment. In certain cases, other triggers may exist, such as the credit downgrade of the
referenced obligors or the inability of the special purpose vehicle for which we have provided liquidity to obtain funding.
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The following table provides details of sold and purchased credit derivatives.
Credit default swaps on:
Corporate bonds
Structured products
Credit protection on:
Default swap index
Commercial mortgage-backed securities index
Asset-backed securities index
Loan deliverable credit default swaps
Total credit derivatives
Protection sold represents the estimated maximum exposure to loss that would be incurred under an assumed hypothetical circumstance, where the value of our interests and any associated collateral declines to zero, without any consideration of recovery or offset from any economic hedges. We believe this hypothetical circumstance to be an extremely remote possibility and accordingly, this required disclosure is not an indication of expected loss. The amounts under non-investment grade represent the notional amounts of those credit derivatives on which we have a higher risk of being required to perform under the terms of the credit derivative and are a function of the underlying assets.
We consider the risk of performance to be high if the underlying assets under the credit derivative have an external rating that is below investment grade or an internal credit default grade that is equivalent thereto. We believe the net protection sold, which is representative of the net notional amount of protection sold and purchased with identical underlyings, in combination with other protection purchased, is more representative of our exposure to loss than either non-investment grade or protection sold. Other protection purchased represents additional protection, which may offset the exposure to loss for protection sold, that was not purchased with an identical underlying of the protection sold.
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Credit-Risk Contingent Features
Certain of our derivative contracts contain provisions whereby if the credit rating of our debt, based on certain major credit rating agencies indicated in the relevant contracts, were to fall below investment grade, the counterparty could demand additional collateral or require termination or replacement of derivative instruments in a net liability position. The aggregate fair value of all derivative instruments with such credit-risk-related contingent features that are in a net liability position was $13.0 billion at September 30, 2011, and $12.6 billion at December 31, 2010, respectively, for which we posted $12.1 billion and $12.0 billion, respectively, in collateral in the normal course of business. If the credit-risk-related contingent features underlying these agreements had been triggered on September 30, 2011, or December 31, 2010, we would have been required to post additional collateral of $945 million or $1.0 billion, respectively, or potentially settle the contract in an amount equal to its fair value.
Counterparty Credit Risk
By using derivatives, we are exposed to counterparty credit risk if counterparties to the derivative contracts do not perform as expected. If a counterparty fails to perform, our counterparty credit risk is equal to the amount reported as a derivative asset on our balance sheet. The amounts reported as a derivative asset are derivative contracts in a gain position, and to the extent subject to master netting arrangements, net of derivatives in a loss position with the same counterparty and cash collateral received. We minimize counterparty credit risk through credit approvals, limits, monitoring procedures, executing master netting arrangements and obtaining collateral, where appropriate. To the extent the master netting arrangements and other criteria meet the applicable requirements, derivatives balances and related cash collateral amounts are shown net in the balance sheet. Counterparty credit risk related to derivatives is considered in determining fair value and our assessment of hedge effectiveness.
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Note 13: Fair Values of Assets and Liabilities
We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Trading assets, securities available for sale, derivatives, substantially all prime residential MHFS, certain commercial LHFS, fair value MSRs, principal investments and securities sold but not yet purchased (short sale liabilities) are recorded at fair value on a recurring basis. We generally do not record our issued debt at fair value. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as certain residential and commercial MHFS, certain LHFS, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets.
Fair Value Hierarchy
We group our assets and liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 – Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
In the determination of the classification of financial instruments in Level 2 or Level 3 of the fair value hierarchy, we consider all available information, including observable market data, indications of market liquidity and orderliness, and our understanding of the valuation techniques and significant inputs used. For securities in inactive markets, we use a predetermined percentage to evaluate the impact of fair value adjustments derived from weighting both external and internal indications of value to determine if the instrument is classified as Level 2 or Level 3. Based upon the specific facts and circumstances of each instrument or instrument category, judgments are made regarding the significance of the Level 3 inputs to the instrument’s fair value measurement in its entirety. If Level 3 inputs are considered significant, the instrument is classified as Level 3.
Determination of Fair Value
We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We maximize the use of observable inputs and minimize
the use of unobservable inputs when developing fair value measurements.
In instances where there is limited or no observable market data, fair value measurements for assets and liabilities are based primarily upon our own estimates or combination of our own estimates and independent vendor or broker pricing, and the measurements are often calculated based on current pricing for products we offer or issue, the economic and competitive environment, the characteristics of the asset or liability and other such factors. As with any valuation technique used to estimate fair value, changes in underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Accordingly, these fair value estimates may not be realized in an actual sale or immediate settlement of the asset or liability.
We incorporate lack of liquidity into our fair value measurement based on the type of asset or liability measured and the valuation methodology used. For example, for certain residential MHFS and certain securities where the significant inputs have become unobservable due to illiquid markets and vendor or broker pricing is not used, we use a discounted cash flow technique to measure fair value. This technique incorporates forecasting of expected cash flows (adjusted for credit loss assumptions and estimated prepayment speeds) discounted at an appropriate market discount rate to reflect the lack of liquidity in the market that a market participant would consider. For other securities where vendor or broker pricing is used, we use either unadjusted broker quotes or vendor prices or vendor or broker prices adjusted by weighting them with internal discounted cash flow techniques to measure fair value. These unadjusted vendor or broker prices inherently reflect any lack of liquidity in the market as the fair value measurement represents an exit price from a market participant viewpoint.
For complete descriptions of the valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for financial instruments not recorded at fair value, see Note 16 in our 2010 Form 10-K. There have been no material changes to our valuation methodologies in 2011.
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Note 13: Fair Values of Assets and Liabilities (continued)
Fair Value Measurements from Independent Brokers or Independent Third Party Pricing Services For certain assets and liabilities, we obtain fair value measurements from independent brokers or independent third party pricing services and record the unadjusted fair value in our
financial statements. The detail by level is shown in the table below. Fair value measurements obtained from independent brokers or independent third party pricing services that we have adjusted to determine the fair value recorded in our financial statements are not included in the following table.
Trading assets (excluding derivatives)
Mortgage-backed securities
Derivatives (trading and other assets)
Derivatives (liabilities)
124
Assets and Liabilities Recorded at Fair Value on a Recurring Basis
The tables below present the balances of assets and liabilities measured at fair value on a recurring basis.
Asset-backed securities
Equity securities
Total trading securities
Other trading assets
Total trading assets (excluding derivatives)
Collateralized debt obligations (2)
Asset-backed securities:
Auto loans and leases
Home equity loans
Other asset-backed securities
Total asset-backed securities
Perpetual preferred securities (3)
Mortgage servicing rights (residential)
Derivative assets:
Credit contracts
Other derivative contracts
Netting
Total derivative assets (5)
Total assets recorded at fair value
Derivative liabilities:
Total derivative liabilities (6)
Short sale liabilities:
Other securities
Total short sale liabilities
Total liabilities recorded at fair value
125
(continued on previous page)
126
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended September 30, 2011, are summarized as follows:
(excluding derivatives):
Perpetual preferred
securities
Net derivative assets and liabilities:
Total derivative contracts
Short sale liabilities
Other liabilities (excluding derivatives)
127
The following table presents gross purchases, sales, issuances and settlements related to the changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended September 30, 2011.
Securities of U.S. states and
political subdivisions
Total trading assets
(excluding derivatives)
128
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2011, are summarized as follows:
Purchases,sales,
issuancesandsettlements,net
Net unrealizedgains (losses)included in net
income relatedto assets andliabilities heldat period end (1)
income
Securities of U.S. states andpolitical subdivisions
Total trading assets(excluding derivatives)
Total mortgage-backedsecurities
Total asset-backed
Total marketableequity securities
Total securitiesavailable for sale
129
The following table presents gross purchases, sales, issuances and settlements related to the changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2011.
130
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter ended September 30, 2010, are summarized as follows:
Balance,beginningof period
Purchases,sales,issuancesandsettlements,net
TransfersintoLevel 3
Transfersout ofLevel 3
Balance,end ofperiod
Net unrealizedgains (losses)included in netincome relatedto assets andliabilities heldat period end (1)
Short sale liabilities (corporate debt securities)
Other liabilities (excluding derivatives) (7)
131
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the nine months ended September 30, 2010, are summarized as follows:
(corporate debt securities)
132
Changes in Fair Value Levels
We monitor the availability of observable market data to assess the appropriate classification of financial instruments within the fair value hierarchy. Changes in economic conditions or model-based valuation techniques may require the transfer of financial instruments from one fair value level to another. The amounts reported as transfers represent the fair value as of the beginning of the quarter in which the transfer occurred.
We evaluate the significance of transfers between levels based upon the nature of the financial instrument and size of the transfer relative to total assets, total liabilities or total earnings. For the first nine months of 2011, there were no significant transfers between Levels 1 and 2. We transferred $612 million of debt securities available for sale from Level 3 to Level 2 due to an increase in the volume of trading activity for certain securities, which resulted in increased occurrences of observable market prices. We also transferred $434 million of securities available for sale from Level 2 to level 3 primarily due to a decrease in liquidity for certain asset-backed securities.
Significant changes to Level 3 assets for the first nine months of 2010, are described as follows:
133
Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis
We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of LOCOM accounting or write-downs of individual
assets. For assets measured at fair value on a nonrecurring basis in the first nine months of 2011, and year ended December 31, 2010, that were still held in the balance sheet at each respective period end, the following table provides the fair value hierarchy and the carrying value of the related individual assets or portfolios at period end.
Mortgages held for sale (1)
Total loans (2)
Mortgage servicing rights (amortized)
Other assets (3)
The following table presents the increase (decrease) in value of certain assets that are measured at fair value on a nonrecurring basis for which a fair value adjustment has been included in the income statement.
Consumer (1)
134
Alternative Investments
The following table summarizes our investments in various types of funds, which are included in trading assets, securities available for sale and other assets. We use the funds’ net asset
values (NAVs) per share as a practical expedient to measure fair value on recurring and nonrecurring bases. The fair values presented in the table are based upon the funds’ NAVs or an equivalent measure.
Redemption
frequency
Redemptionnotice
period
Offshore funds
Funds of funds
Hedge funds
Private equity funds
Venture capital funds
N/A - Not applicable
Offshore funds primarily invest in investment grade European fixed-income securities. Redemption restrictions are in place for investments with a fair value of $66 million and $74 million at September 30, 2011, and December 31, 2010, respectively, due to lock-up provisions that will remain in effect until November 2013.
Private equity funds invest in equity and debt securities issued by private and publicly-held companies in connection with leveraged buyouts, recapitalizations and expansion opportunities. Substantially all of these investments do not allow redemptions. Alternatively, we receive distributions as the underlying assets of the funds liquidate, which we expect to occur over the next nine years.
Venture capital funds invest in domestic and foreign companies in a variety of industries, including information technology, financial services and healthcare. These investments can never be redeemed with the funds. Instead, we receive distributions as the underlying assets of the fund liquidate, which we expect to occur over the next six years.
135
Fair Value Option
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. 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.
Upon the acquisition of Wachovia, we elected to measure at fair value certain portfolios of LHFS that we intend to hold for trading purposes and that may be economically hedged with
derivative instruments. In addition, we elected to measure at fair value certain letters of credit that are hedged with derivative instruments to better reflect the economics of the transactions. These letters of credit are included in trading account assets or liabilities.
Upon the adoption of new consolidation guidance on January 1, 2010, we elected to measure at fair value the eligible assets (loans) and liabilities (long-term debt) of certain nonconforming mortgage loan securitization VIEs. We elected the fair value option for such newly consolidated VIEs to continue fair value accounting as our interests prior to consolidation were predominantly carried at fair value with changes in fair value recognized in earnings.
The following table reflects the differences between fair value carrying amount of certain assets and liabilities for which we have elected the fair value option and the contractual aggregate unpaid principal amount at maturity.
Mortgages held for sale:
Loans 90 days or more past due and still accruing
Loans held for sale:
136
The assets accounted for under the fair value option are initially measured at fair value. Gains and losses from initial measurement and subsequent changes in fair value are recognized in earnings. The changes in fair value related to
initial measurement and subsequent changes in fair value included in earnings for these assets measured at fair value are shown, by income statement line item, below.
Othernoninterestincome
Other interest held
The following table shows the estimated gains and losses from earnings attributable to instrument-specific credit risk related to assets accounted for under the fair value option.
Gains (losses) attributable to instrument-specific credit risk:
For performing loans, instrument-specific credit risk gains or losses were derived principally by determining the change in fair value of the loans due to changes in the observable or implied credit spread. Credit spread is the market yield on the loans less the relevant risk-free benchmark interest rate. In recent years spreads have been significantly affected by the lack of liquidity in the secondary market for mortgage loans. For nonperforming loans, we attribute all changes in fair value to instrument-specific credit risk.
137
Disclosures about Fair Value of Financial Instruments
The table below is a summary of fair value estimates for financial instruments, excluding short-term financial assets and liabilities because carrying amounts approximate fair value, and excluding financial instruments recorded at fair value on a recurring basis. The carrying amounts in the following table are recorded in the balance sheet under the indicated captions.
We have not included assets and liabilities that are not financial instruments in our disclosure, such as the value of the long-term relationships with our deposit, credit card and trust customers, amortized MSRs, premises and equipment, goodwill and other intangibles, deferred taxes and other liabilities. The total of the fair value calculations presented does not represent, and should not be construed to represent, the underlying value of the Company.
Financial assets
Loans held for sale (2)
Loans, net (3)
Nonmarketable equity investments (cost method)
Financial liabilities
Long-term debt (3)(4)
Loan commitments, standby letters of credit and commercial and similar letters of credit are not included in the table above. A reasonable estimate of the fair value of these instruments is the carrying value of deferred fees plus the related allowance. This amounted to $541 million at September 30, 2011, and $673 million at December 31, 2010.
138
Note 14: Preferred Stock
We are authorized to issue 20 million shares of preferred stock and 4 million shares of preference stock, both without par value. Preferred shares outstanding rank senior to common shares both as to dividends and liquidation preference but have no general voting rights. We have not issued any preference shares under this authorization. If issued, preference shares would be limited to one vote per share. Our total issued and outstanding
preferred stock includes Dividend Equalization Preferred (DEP) shares and Series I, J, K and L, which are presented in the following tables, and Employee Stock Ownership Plan (ESOP) Cumulative Convertible Preferred Stock, which are presented in the table on the following page.
DEP Shares
Dividend Equalization Preferred Shares
Series A
Non-Cumulative Perpetual Preferred Stock
Series B
Series G
7.25% Class A Preferred Stock
Series H
Floating Class A Preferred Stock
Series I
5.80% Fixed to Floating Class A Preferred Stock
Series J
8.00% Non-Cumulative Perpetual Class A Preferred Stock
Series K
7.98% Fixed-to-Floating Non-Cumulative Perpetual Class A Preferred Stock
Series L
7.50% Non-Cumulative Perpetual Convertible Class A Preferred Stock
139
Note 14: Preferred Stock (continued)
Series I (1)
Series J (1)
8.00% Non-Cumulative Perpetual Class A
Preferred Stock
7.98% Fixed-to-Floating Non-Cumulative
Perpetual Class A Preferred Stock
Series L (1)
7.50% Non-Cumulative Perpetual
Convertible Class A Preferred Stock
In March 2011, the Company issued preferred stock for Series I (25,010 shares with a par value of $2.5 billion) to an unconsolidated wholly-owned trust related to our income trust securities.
Prior to the October 2011 redemption of $5.8 billion of trust preferred securities, we had a commitment to issue preferred stock for Series A ($2.5 billion) and Series B ($1.8 billion) to unconsolidated wholly-owned trusts. The issuance dates were dependent on the sale of our income trust securities held by these trusts to third party investors. Effective with the redemption, we no longer have the commitment. See Note 7 for additional information on our trust preferred securities. We do not have a commitment to issue Series G or H preferred stock.
140
ESOP CUMULATIVE CONVERTIBLE PREFERRED STOCK All shares of our ESOP Cumulative Convertible Preferred Stock (ESOP Preferred Stock) were issued to a trustee acting on behalf of the Wells Fargo & Company 401(k) Plan (the 401(k) Plan). Dividends on the ESOP Preferred Stock are cumulative from the date of initial issuance and are payable quarterly at annual rates based upon the year of issuance. Each share of ESOP Preferred Stock released from the unallocated reserve of the 401(k) Plan is converted into shares of our common stock based on the stated
value of the ESOP Preferred Stock and the then current market price of our common stock. The ESOP Preferred Stock is also convertible at the option of the holder at any time, unless previously redeemed. We have the option to redeem the ESOP Preferred Stock at any time, in whole or in part, at a redemption price per share equal to the higher of (a) $1,000 per share plus accrued and unpaid dividends or (b) the fair market value, as defined in the Certificates of Designation for the ESOP Preferred Stock.
(in millions, except shares)
ESOP Preferred Stock
$1,000 liquidation preference per share
2008
2007
2006
2005
2004
2003
2002
Total ESOP Preferred Stock (1)
Unearned ESOP shares (2)
141
Note 15: Employee Benefits
We sponsor a noncontributory qualified defined benefit retirement plan, the Wells Fargo & Company Cash Balance Plan (Cash Balance Plan), which covers eligible employees of
Wells Fargo; the benefits earned under the Cash Balance Plan were frozen effective July 1, 2009.
The net periodic benefit cost was:
Service cost
Interest cost
Expected return on plan assets
Amortization of net actuarial loss
Amortization of prior service credit
Settlement
Curtailment gain (loss)
Net periodic benefit cost (income)
142
Note 16: Earnings Per Common Share
The table below shows earnings per common share and diluted earnings per common share and reconciles the numerator and denominator of both earnings per common share calculations.
Less: Preferred stock dividends and other (1)
Wells Fargo net income applicable to common stock (numerator)
Average common shares outstanding (denominator)
Per share
Add: Stock Options
Restricted share rights
Diluted average common shares outstanding (denominator)
The following table presents the outstanding options and warrants to purchase shares of common stock that were anti-dilutive (the exercise price was higher than the
weighted-average market price), and therefore not included in the calculation of diluted earnings per common share.
Options
Warrants
143
Note 17: Operating Segments
We have three operating segments for management reporting: Community Banking; Wholesale Banking; and Wealth, Brokerage and Retirement. The results for these operating segments are based on our management accounting process, for which there is no comprehensive, authoritative guidance equivalent to GAAP for financial accounting. The management accounting process measures the performance of the operating segments based on our management structure and is not necessarily comparable with similar information for other financial services companies. We define our operating segments by product type and customer segment. If the management structure and/or the allocation process changes, allocations, transfers and assignments may change. In first quarter 2010, we conformed certain funding and allocation methodologies of legacy Wachovia to those of Wells Fargo; in addition, integration expense related to mergers other than the Wachovia merger is now included in segment results. In fourth quarter 2010, we aligned certain lending businesses into Wholesale Banking from Community Banking to reflect our previously announced restructuring of Wells Fargo Financial. In first quarter 2011, we realigned a private equity business into Wholesale Banking from Community Banking. The prior periods have been revised to reflect these changes.
Community Banking offers a complete line of diversified financial products and services to consumers and small businesses with annual sales generally up to $20 million in which the owner generally is the financial decision maker. Community Banking also offers investment management and other services to retail customers and securities brokerage through affiliates. These products and services include the Wells Fargo Advantage FundsSM, a family of mutual funds. Loan products include lines of credit, auto floor plan lines, equity lines and loans, equipment and transportation loans, education loans, origination and purchase of residential mortgage loans and servicing of mortgage loans and credit cards. Other credit products and financial services available to small businesses and their owners include equipment leases, real estate and other commercial financing, Small Business Administration financing, venture capital financing, cash management, payroll services, retirement plans, Health Savings Accounts, credit cards, and merchant payment processing. Community Banking also purchases sales finance contracts from retail merchants throughout the United States and directly from auto dealers in Puerto Rico. Consumer and business deposit products include checking accounts, savings deposits, market rate accounts, Individual Retirement Accounts, time deposits and debit cards.
Community Banking serves customers through a complete range of channels, including traditional banking stores, in-store banking centers, business centers, ATMs, Online and Mobile Banking, and Wells Fargo Customer Connection, a 24-hours a day, seven days a week telephone service.
Wholesale Banking provides financial solutions to businesses across the United States with annual sales generally in excess of $20 million and to financial institutions globally. Wholesale
Banking provides a complete line of commercial, corporate, capital markets, cash management and real estate banking products and services. These include traditional commercial loans and lines of credit, letters of credit, asset-based lending, equipment leasing, international trade facilities, trade financing, collection services, foreign exchange services, treasury management, investment management, institutional fixed-income sales, interest rate, commodity and equity risk management, online/electronic products such as the Commercial Electronic Office® (CEO®) portal, insurance, corporate trust fiduciary and agency services, and investment banking services. Wholesale Banking manages customer investments through institutional separate accounts and mutual funds, including the Wells Fargo Advantage Funds and Wells Capital Management. Wholesale Banking also supports the CRE market with products and services such as construction loans for commercial and residential development, land acquisition and development loans, secured and unsecured lines of credit, interim financing arrangements for completed structures, rehabilitation loans, affordable housing loans and letters of credit, permanent loans for securitization, CRE loan servicing and real estate and mortgage brokerage services.
Wealth, Brokerage and Retirement provides a full range of financial advisory services to clients using a planning approach to meet each client’s needs. Wealth Management provides affluent and high net worth clients with a complete range of wealth management solutions, including financial planning, private banking, credit, investment management and trust. Family Wealth meets the unique needs of ultra high net worth customers. Brokerage serves customers’ advisory, brokerage and financial needs as part of one of the largest full-service brokerage firms in the United States. Retirement is a national leader in providing institutional retirement and trust services (including 401(k) and pension plan record keeping) for businesses, retail retirement solutions for individuals, and reinsurance services for the life insurance industry.
Other includes corporate items (such as integration expenses related to the Wachovia merger) not specific to a business segment and elimination of certain items that are included in more than one business segment.
144
(income/expense in millions,
Wealth,Brokerageand
Retirement
Net interest income (2)
Provision (reversal of provision)
for credit losses
Income (loss) before income
tax expense (benefit)
Income tax expense (benefit)
Net income (loss) before
noncontrolling interests
Less: Net income from
Net income (loss) (3)
145
Note 18: Condensed Consolidating Financial Statements
Following are the condensed consolidating financial statements of the Parent and Wells Fargo Financial, Inc. and its owned subsidiaries (WFFI).
Condensed Consolidating Statement of Income
Dividends from subsidiaries:
Bank
Nonbank
Interest income from loans
Interest income from subsidiaries
Fee income – nonaffiliates
Salaries and benefits
Income (loss) before income tax expense (benefit) andequity in undistributed income of subsidiaries
Equity in undistributed income of subsidiaries
Net income (loss) before noncontrolling interests
Parent, WFFI, Other and Wells Fargo net income (loss)
146
Condensed Consolidating Statements of Income
consolidating
subsidiaries
Consolidated
Company
Income (loss) before income tax expense (benefit) and equity in undistributed income of subsidiaries
147
Note 18: Condensed Consolidating Financial Statements (continued)
Condensed Consolidating Balance Sheets
Cash and cash equivalents due from:
Subsidiary banks
Nonaffiliates
Mortgages and loans held for sale
Loans to subsidiaries:
Investments in subsidiaries:
Liabilities and equity
Indebtedness to subsidiaries
Parent, WFFI, Other and Wells Fargo stockholders’ equity
148
Condensed Consolidating Statements of Cash Flows
subsidiaries/
eliminations
Net repayments from (advances to) subsidiaries
Capital notes and term loans made to subsidiaries
Principal collected on notes/loans made to subsidiaries
Net decrease (increase) in investment in subsidiaries
149
Note 19: Regulatory and Agency Capital Requirements
The Company and each of its subsidiary banks are subject to regulatory capital adequacy requirements promulgated by federal regulatory agencies. The Federal Reserve establishes capital requirements, including well capitalized standards, for the consolidated financial holding company, and the OCC has similar requirements for the Company’s national banks, including Wells Fargo Bank, N.A.
We do not consolidate our wholly-owned trusts (the Trusts) formed solely to issue trust preferred and preferred purchase securities (the Securities). Securities issued by the Trusts includable in Tier 1 capital were $7.5 billion at September 30, 2011. Since December 31, 2010, we have called $9.2 billion of trust preferred securities, and also issued $2.5 billion in Series I Preferred Stock, replacing certain preferred purchase securities reflected in the amount of Securities issued by the Trusts includable in Tier 1 capital at December 31, 2010. The Series I Preferred Stock was included in preferred stock
(Note 14), as a separate component of Tier 1 capital. The junior subordinated debentures held by the Trusts were included in the Company’s long-term debt.
Certain subsidiaries of the Company are approved seller/servicers, and are therefore required to maintain minimum levels of shareholders’ equity, as specified by various agencies, including the United States Department of Housing and Urban Development, GNMA, FHLMC and FNMA. At September 30, 2011, each seller/servicer met these requirements. Certain broker-dealer subsidiaries of the Company are subject to SEC Rule 15c3-1 (the Net Capital Rule), which requires that we maintain minimum levels of net capital, as defined. At September 30, 2011, each of these subsidiaries met these requirements.
The following table presents regulatory capital information for Wells Fargo & Company and Wells Fargo Bank, N.A.
Regulatory capital:
Tier 1
Assets:
Risk-weighted
Adjusted average (2)
Tier 1 leverage (2)
150
Glossary of Acronyms
ACL
ALCO
ARS
ASC
ASU
ARM
AVM
CD
CDO
CLO
CLTV
CPP
CPR
CRE
DPD
ESOP
FAS
FASB
FDIC
FFELP
FHA
FHLB
FHLMC
FICO
FNMA
FRB
GAAP
GNMA
GSE
HAMP
HPI
HUD
LHFS
LIBOR
LOCOM
LTV
MBS
MHA
MHFS
MSR
MTN
NAV
NPA
OCC
OCI
OTC
OTTI
PCI Loans
PTPP
RBC
ROA
ROE
SEC
S&P
SPE
TARP
TDR
VA
VaR
WFFCC
WFFI
151
PART II – OTHER INFORMATION
Information in response to this item can be found in Note 11 (Legal Actions) to Financial Statements in this Report which information is incorporated by reference into this item.
Information in response to this item can be found under the “Financial Review – Risk Factors” section in this Report which information is incorporated by reference into this item.
The following table shows Company repurchases of its common stock for each calendar month in the quarter ended September 30, 2011.
Total number
of shares
repurchased (1)
Maximum number of
shares that may yet
be purchased under
the authorizations
July
August
September
The following table shows Company repurchases of the warrants for each calendar month in the quarter ended September 30, 2011.
of warrantsrepurchased (1)
Maximum dollar value
of warrants that
may yet be purchased
152
A list of exhibits to this Form 10-Q is set forth on the Exhibit Index immediately preceding such exhibits and is incorporated herein by reference.
The Company’s SEC file number is 001-2979. On and before November 2, 1998, the Company filed documents with the SEC under the name Norwest Corporation. The former Wells Fargo & Company filed documents under SEC file number 001-6214.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Executive Vice President and Controller
(Principal Accounting Officer)
153
EXHIBIT INDEX
Exhibit
Number
Description
Location
154
31(a)
Certification of principal executive officer pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
31(b)
Certification of principal financial officer pursuant to Section 302
32(a)
Certification of Periodic Financial Report by Chief Executive Officer
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and 18 U.S.C. § 1350.
32(b)
Certification of Periodic Financial Report by Chief Financial Officer
155