PNC Bank 2007 Annual Report Download - page 100

During the next twelve months, we expect to reclassify to
earnings $75 million of pretax net gains, or $49 million after-
tax, on cash flow hedge derivatives currently reported in
accumulated other comprehensive income (loss). This amount
could differ from amounts actually recognized due to changes
in interest rates and the addition of other hedges subsequent to
December 31, 2007. These net gains are anticipated to result
from net cash flows on receive fixed interest rate swaps that
would impact interest income recognized on the related
floating rate commercial loans.
As of December 31, 2007 we have determined that there were
no hedging positions where it was probable that certain
forecasted transactions may not occur within the originally
designated time period.
For those hedge relationships that require testing for
ineffectiveness, any ineffectiveness present in the hedge
relationship is recognized in current earnings. The ineffective
portion of the change in value of these derivatives resulted in
net losses of $1 million for 2007 and $4 million for 2006.
Free-Standing Derivatives
To accommodate customer needs, we also enter into financial
derivative transactions primarily consisting of interest rate
swaps, interest rate caps and floors, futures, swaptions, and
foreign exchange and equity contracts. We primarily manage
our market risk exposure from customer positions through
transactions with third-party dealers. The credit risk associated
with derivatives executed with customers is essentially the
same as that involved in extending loans and is subject to
normal credit policies. We may obtain collateral based on our
assessment of the customer. For derivatives not designated as
an accounting hedge, the gain or loss is recognized in
noninterest income.
Also included in free-standing derivatives are transactions that
we enter into for risk management and proprietary purposes
that are not designated as accounting hedges, primarily
interest rate, basis and total rate of return swaps, interest rate
caps, floors and futures contracts, credit default swaps, option
and foreign exchange contracts and certain interest rate-locked
loan origination commitments as well as commitments to buy
or sell mortgage loans.
Basis swaps are agreements involving the exchange of
payments, based on notional amounts, of two floating rate
financial instruments denominated in the same currency, one
pegged to one reference rate and the other tied to a second
reference rate (e.g., swapping payments tied to one-month
LIBOR for payments tied to three-month LIBOR). We use
these contracts to mitigate the impact on earnings of exposure
to a certain referenced interest rate.
We purchase credit default swaps (“CDS”) to mitigate the risk
of economic loss on a portion of our loan exposure. We also
sell loss protection to mitigate the net premium cost and the
impact of mark-to-market accounting on the CDS in cases
where we buy protection to hedge the loan portfolio and to
take proprietary trading positions. The fair values of these
derivatives typically are based on the change in value, due to
changing credit spreads.
Interest rate lock commitments for, as well as commitments to
buy or sell, mortgage loans that we intend to sell are
considered free-standing derivatives. Our interest rate
exposure on certain commercial mortgage interest rate lock
commitments is economically hedged with pay-fixed interest
rate swaps and forward sales agreements. These contracts
mitigate the impact on earnings of exposure to a certain
referenced rate.
Free-standing derivatives also include positions we take based
on market expectations or to benefit from price differentials
between financial instruments and the market based on stated
risk management objectives.
Derivative Counterparty Credit Risk
By purchasing and writing derivative contracts we are exposed
to credit risk if the counterparties fail to perform. Our credit
risk is equal to the fair value gain in the derivative contract.
We minimize credit risk through credit approvals, limits,
monitoring procedures and collateral requirements. We
generally enter into transactions with counterparties that carry
high quality credit ratings.
We enter into risk participation agreements to share some of
the credit exposure with other counterparties related to interest
rate derivative contracts or to take on credit exposure to
generate revenue. We will make/receive payments under these
guarantees if a customer defaults on its obligation to perform
under certain credit agreements. Risk participation agreements
entered into prior to July 1, 2003 were considered financial
guarantees and therefore are not included in derivatives.
Agreements entered into subsequent to June 30, 2003 are
included in the derivatives table that follows. We determine
that we meet our objective of reducing credit risk associated
with certain counterparties to derivative contracts when the
participation agreements share in their proportional credit
losses of those counterparties.
We generally have established agreements with our major
derivative dealer counterparties that provide for exchanges of
marketable securities or cash to collateralize either party’s
positions. At December 31, 2007 we held short-term
investments, US government securities and mortgage-backed
securities with a fair value of $354 million. We pledged short-
term investments with a fair value of $226 million under these
agreements.
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