Citibank 2009 Annual Report Download - page 91

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Interest Rate Risk Associated with Consumer Mortgage
Lending Activity
Citigroup originates and funds mortgage loans. As with all other lending
activity, this exposes Citigroup to several risks, including credit, liquidity and
interest rate risks. To manage credit and liquidity risk, Citigroup sells most
of the mortgage loans it originates, but retains the servicing rights. These
sale transactions create an intangible asset referred to as mortgage servicing
rights (MSRs). The fair value of this asset is primarily affected by changes
in prepayments that result from shifts in mortgage interest rates. Thus,
by retaining the servicing rights of sold mortgage loans, Citigroup is still
exposed to interest rate risk.
In managing this risk, Citigroup hedges a significant portion of the value
of its MSRs through the use of interest rate derivative contracts, forward
purchase commitments of mortgage-backed securities, and purchased
securities classified as trading (primarily mortgage-backed securities
including principal-only strips).
Since the change in the value of these hedging instruments does not
perfectly match the change in the value of the MSRs, Citigroup is still
exposed to what is commonly referred to as “basis risk.” Citigroup manages
this risk by reviewing the mix of the various hedging instruments referred to
above on a daily basis.
Citigroup’s MSRs totaled $6.530 billion and $5.657 billion at
December 31, 2009 and December 31, 2008, respectively. For additional
information on Citi’s MSRs, see Notes 19 and 23 to the Consolidated
Financial Statements.
As part of the mortgage lending activity, Citigroup commonly enters into
purchase commitments to fund residential mortgage loans at specific interest
rates within a given period of time, generally up to 60 days after the rate has
been set. If the resulting loans from these commitments will be classified as
loans held-for-sale, Citigroup accounts for the commitments as derivatives.
Accordingly, the initial and subsequent changes in the fair value of these
commitments, which are driven by changes in mortgage interest rates, are
recognized in current earnings after taking into consideration the likelihood
that the commitment will be funded.
Citigroup hedges its exposure to the change in the value of these
commitments by utilizing hedging instruments similar to those referred
to above.