eTrade 2002 Annual Report Download - page 75

Table of Contents
Index to Financial Statements
portion of our revenues in the foreseeable future. Like other financial services firms, we are directly affected by national and global economic
and political conditions, broad trends in business and finance, disruptions to the securities markets and changes in volume and price levels of
securities and futures transactions.
A significant downturn in the U.S. securities markets has been occurring since March 2000, resulting in industry-wide declines in transaction
volume. The decrease in transaction volume has been more significant for us with respect to our less active customers, increasing our
dependence on our more active Power E*TRADE and E*TRADE Professional Trading customers who receive more favorable pricing based on
their transaction volume. Decreases in volumes, as well as securities prices, are also typically associated with a decrease in margin borrowing.
Because we generate revenue from interest charged on margin borrowing, such decreases result in a reduction of revenue to E*TRADE
Clearing. When transaction volume is low, our operating results are harmed in part because some of our overhead costs remain relatively fixed.
Downturns in the securities markets increase the credit risk associated with margin lending or stock loan transactions
We permit customers to purchase securities on margin. When the market declines rapidly, there is an increased risk that the value of the
collateral we hold in connection with these transactions could fall below the amount of a customer’ s indebtedness. Similarly, as part of our
broker-dealer operations, we frequently enter into arrangements with other broker-dealers for the lending of various securities. Under regulatory
guidelines, when we borrow or lend securities, we must generally simultaneously disburse or receive cash deposits. We may risk losses if there
are sharp changes in market values of many securities and the counter-parties to the borrowing and lending transactions fail to honor their
commitments. The recent downturn in public equity markets has led to a greater risk that parties to stock lending transactions may fail to meet
their commitments.
We may be unsuccessful in managing the effects of changes in interest rates and the interest-bearing assets in our portfolio
The results of operations for the Bank depend in large part upon the level of its net interest income, that is, the difference between interest
income from interest-earning assets (such as loans and mortgage-backed securities) and interest expense on interest-bearing liabilities (such as
deposits and borrowings). Changes in market interest rates and the yield curve could reduce the value of the Bank’ s financial assets and reduce
net interest income. Many factors affect interest rates, including governmental monetary policies and domestic and international economic and
political conditions.
The Bank is exposed to interest rate risk in various ways, including the following:
• As interest rates have declined, we have experienced increased demand for and revenues from mortgage loans. If interest rates increase,
we would expect a potentially significant decline in our mortgage business.
• As part of its diversified portfolio of interest-bearing assets, the Bank holds a portfolio of corporate bonds. With the recent economic
downturn, there is an increased risk that some of these corporate bonds may become impaired before reaching maturity, or that they may
not realize their full principal value upon maturity, which could cause the Bank’ s portfolio to suffer impairment charges as losses are
realized.
The Bank attempts to mitigate interest rate risk in part by using derivative contracts that are designed to offset, in whole or in part, the
variability in value or cash flow of various assets or liabilities caused by changes in interest rates. There can be no assurances that these
derivative contracts will offer the intended protection against interest rate risk. SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities , which we adopted on October 1, 2000, requires that the hedge ineffectiveness, or the difference between the changes in
value of the hedged item versus the change in value of the hedging instruments, be recognized in earnings as of the reporting date. Our financial
results may prove to be more volatile due to this reporting requirement.
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