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the loans that will be ultimately delivered into a loan sale. At April 30, period on the mortgage loans is different from the floating interest rate
2006, we recorded an asset of $2.0 million reflecting the fair value of on the bonds sold in the securitization.
these instruments. We enter into interest rate caps and swaps to mitigate interest rate
Interest rate swaps represent an agreement to exchange interest rate risk associated with mortgage loans that will be securitized and residual
payments, whereby we pay a fixed rate and receive a floating rate. Put interests that are classified as trading securities because they will be
options on Eurodollar futures represent the right to sell a Eurodollar sold in a subsequent NIM transaction. The caps and swaps enhance the
futures contract at a specified price in the future. These swap and put marketability of the securitization and NIM transactions. An interest
option contracts increase in value as rates rise and decrease in value as rate cap represents a right to receive cash if interest rates rise above a
rates fall. At April 30, 2006, the interest rate swaps and put options contractual strike rate, its value therefore increases as interest rates
provided interest risk coverage of $9.9 billion. At April 30, 2006, we had rise. The interest rate used in our interest rate caps and the floating rate
assets recorded at fair values of $8.8 million and $3.3 million on our used in swaps are based on LIBOR. At April 30, 2006 we had no assets
balance sheet related to interest rate swaps and put options, or liabilities recorded related to interest rate caps.
respectively. See table below for sensitivities to changes in interest rates for
See table below for sensitivities to changes in interest rates. residual interests, caps and swaps. See Item 8, note 5 to the
INTEREST RATE RISK – PRIME ORIGINATIONS –At April 30, 2006, we consolidated financial statements for additional analysis of interest rate
had commitments to fund prime mortgage loans totaling $83.2 million. risk and other financial risks impacting residual interests.
We regularly enter into rate-lock commitments with our customers to It is our policy to use derivative instruments only for the purpose of
fund prime mortgage loans within specified periods of time. The fair offsetting or reducing the risk of loss associated with a defined or
value of rate-lock commitments is calculated based on the current quantified exposure.
market pricing of short sales of FNMA, FHLMC and GNMA mortgage- MORTGAGE SERVICING RIGHTS –Declining interest rates may cause
backed securities and the coupon rates of the eligible loans. At April 30, increased refinancing activity, which reduces the life of the loans
2006, we recorded a liability at a fair value of $0.3 million related to rate- underlying the residual interests and MSRs, thereby generally reducing
lock commitments. their fair value. The fair value of MSRs generally increases in a rising
We sell short FNMA, FHLMC and GNMA mortgage-backed securities rate environment, although MSRs are recorded at the lower of cost or
to reduce the risk related to our prime commitments to fund fixed-rate market value. Reductions in the fair value of these assets impact
prime loans. The position on certain, or all, of the fixed-rate mortgage earnings through impairment charges. See Item 8, note 5 to our
loans is closed approximately 10-15 days prior to standard Public consolidated financial statements for further sensitivity analysis of
Securities Association (PSA) settlement dates. At April 30, 2006 we other MSR valuation assumptions.
recorded an asset of $0.8 million related to these instruments.
To finance our prime originations, we use a warehouse facility with
INVESTMENT SERVICES
capacity up to $25 million, which bears interest at one-month LIBOR INTEREST RATE RISK –HRBFA holds interest bearing receivables from
plus 140 to 200 basis points. As of April 30, 2006, the balance customers, brokers, dealers and clearing organizations, which consist
outstanding under this facility was $1.6 million. primarily of amounts due on margin transactions and are generally
DELIVERY RISK –We have exposure to delivery risk in our non-prime short-term in nature. We fund these short-term assets with short-term
origination operations, which regularly enter into forward loan sale variable rate liabilities from customers, brokers and dealers, including
commitments prior to loans being originated. It is possible that we will stock loan activity. Although there may be differences in the timing of
be unable to originate the loans or that the loans originated will not the re-pricing related to these assets and liabilities, we believe we are
meet the required characteristics of the forward loan sale commitments. not significantly exposed to interest rate risk in this area. As a result,
Several remedies are available, although use of the remedies could any change in interest rates would not materially impact our
reduce the execution price or the effectiveness of the forward loan sale consolidated earnings.
commitment in reducing interest rate risk. Our fixed-income trading portfolio is affected by changes in market
RESIDUAL INTERESTS –Relative to modeled assumptions, an rates and prices. The risk is the loss of income arising from adverse
increase or decrease in interest rates would impact the value of our changes in the value of the trading portfolio. We value the trading
residual interests and could affect accretion income related to our portfolio at quoted market prices and the market value of our trading
residual interests. Residual interests bear the interest rate risk portfolio at April 30, 2006 was approximately $16.1 million, net of
embedded within the securitization due to an initial fixed-rate period on $0.5 million in securities sold short. See table below for sensitivities to
the loans versus a floating-rate funding cost. Residual interests also bear changes in interest rates. With respect to our fixed-income securities
the on-going risk that the floating interest rate earned after the fixed portfolio, we manage our market price risk exposure by limiting
38
H&R BLOCK 2006 Form 10K