Charles Schwab 2015 Annual Report Download - page 33

THE CHARLES SCHWAB CORPORATION
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lending, its role as a counterparty in financial contracts and investing activities, and indirectly from the investing activities of
certain of the proprietary funds the Company sponsors.
When clients purchase securities on margin, borrow on lines of credit collateralized by securities, or trade options or futures,
the Company is subject to the risk that clients may default on their obligations when the value of the securities and cash in
their accounts falls below the amount of clients’ indebtedness. Abrupt changes in securities valuations and the failure of
clients to meet margin calls could result in substantial losses.
The Company has exposure to credit risk associated with its securities available for sale and securities held to maturity
portfolios, which include U.S. agency and non-agency mortgage-backed securities, asset-backed securities, corporate debt
securities, U.S. agency notes, certificates of deposit, and commercial paper among other investments. These instruments are
also subject to price fluctuations as a result of changes in the financial market’s assessment of issuer credit quality, increases
in the unemployment rate, delinquency and default rates, housing price declines, changes in prevailing interest rates and other
economic factors. A failure to raise the U.S. debt limit and/or a downgrade of the U.S. government’s credit rating could
decrease the value of the Company’s securities in both the available for sale and held to maturity portfolios.
Loss of value of securities available for sale and securities held to maturity can negatively affect earnings if management
determines that such securities are other than temporarily impaired. The evaluation of whether other-than-temporary
impairment (OTTI) exists is a matter of judgment, which includes the assessment of several factors. If management
determines that a security is other-than-temporarily impaired, the cost basis of the security may be adjusted and a
corresponding loss may be recognized in current earnings. Deterioration in the performance of securities available for sale
and securities held to maturity could result in the recognition of future impairment charges. See “Item 7 – Management’s
Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Estimates.”
The Company’s bank loans primarily consist of First Mortgages, HELOCs, and PALs. Increases in delinquency and default
rates, housing and stock price declines, increases in the unemployment rate, and other economic factors can result in charges
for loan loss reserves and write downs on such loans.
Heightened credit exposures to specific counterparties or instruments (concentration risk) can increase the Company’s risk of
loss. Examples of the Company’s credit concentration risk include:
x large positions in financial instruments collateralized by assets with similar economic characteristics or in securities
of a single issuer or industry;
x mortgage loans and HELOCs to banking clients which are secured by properties in the same geographic region; and
x margin, pledged asset, and securities lending activities collateralized by securities of a single issuer or industry.
The Company may also be subject to concentration risk when lending to a particular counterparty, borrower or issuer.
The Company sponsors a number of proprietary money market mutual funds and other proprietary funds. Although the
Company has no obligation to do so, the Company may decide for competitive or other reasons to provide credit, liquidity or
other support to its funds in the event of significant declines in valuation of fund holdings or significant redemption activity
that exceeds available liquidity. Such support could cause the Company to take significant charges, could reduce the
Company’s liquidity and, in certain situations, could, with respect to proprietary funds other than money market mutual
funds, result in the Company having to consolidate a supported fund in its financial statements. If the Company chose not to
provide credit, liquidity or other support in such a situation, the Company could suffer reputational damage and its business
could be adversely affected.
Significant interest rate changes could affect the Company’s profitability and financial condition.
The Company is exposed to interest rate risk primarily from changes in the interest rates on its interest-earning assets (such as
cash equivalents, short- and long-term investments, and mortgage and margin loans) relative to changes in the costs of its
funding sources (including bank deposits and cash in brokerage accounts, short-term borrowings, and long-term debt).
Changes in interest rates can affect the interest earned on interest-earning assets differently than the interest the Company
pays on its interest-bearing liabilities. In addition, certain funding sources do not bear interest and their cost therefore does
not vary. Overall, the Company is positioned to benefit from a rising interest rate environment; the Company could be
adversely affected by a decline in interest rates if the rates the Company earns on interest-earning assets decline more than