PNC Bank 2008 Annual Report Download - page 138

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
tied 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 and residential mortgage
interest rate lock commitments as well as commercial and
residential mortgage loans held for sale is economically
hedged with total rate of return swaps, pay-fixed interest rate
swaps, credit derivatives and forward sales agreements. These
contracts mitigate the impact on earnings of exposure to a
certain referenced rate. The fair value of loan commitments is
based on the estimated fair value of the underlying loan and
the probability that the loan will fund within the terms of the
commitment. The fair value of the loan commitment also
takes into account the fair value of the embedded servicing
right pursuant to SAB 109.
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.
Derivatives Used to Hedge MSRs
The derivative portfolio also includes derivative financial
instruments not included in SFAS 133 hedging strategies. The
majority of these derivatives are used to manage interest rate
and prepayment risk related to residential mortgage servicing
rights (MSRs), residential and commercial real estate loans
held for sale, and interest rate lock commitments, all of which
are carried at fair value consistent with the accounting for the
derivatives.
Derivative Counterparty Credit Risk
By purchasing and writing derivative contracts we are exposed
to credit risk if the counterparties fail to perform. We seek to
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. Nonperformance risk including
credit risk is included in the determination of the estimated net
fair value.
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, 2008, we held cash, which is
included in other borrowed funds on our Consolidated Balance
Sheet, US government securities and mortgage-backed
securities with a total fair value of $1.4 billion. We pledged
cash, which is included in short-term investments on our
Consolidated Balance Sheet, and US government securities of
$1.2 billion under these agreements.
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