Morgan Stanley 1998 Annual Report Download - page 47

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MORGAN STANLEY DEAN WITTER *1998 ANNUAL REPORT
CONSUMER LENDING AND RELATED ACTIVITIES
Interest Rate Risk and Management
In its consumer lending activities, the Company is exposed to mar-
ket risk primarily from changes in interest rates. Such changes in
interest rates impact interest earning assets, principally credit card
and other consumer loans and net servicing fees received in con-
nection with consumer loans sold through asset securitizations, as
well as the interest-sensitive liabilities which finance these assets,
including asset securitizations, commercial paper, medium-term
notes, long-term borrowings, deposits, asset-backed commercial
paper, Federal Funds and short-term bank notes.
The Company’s interest rate risk management policies
are designed to reduce the potential volatility of earnings which may
arise from changes in interest rates. This is accomplished primar-
ily by matching the repricing of credit card and consumer loans and
the related financing. To the extent that asset and related financing
repricing characteristics of a particular portfolio are not matched effec-
tively, the Company utilizes interest rate derivative contracts, such
as swap and cap agreements, to achieve its matched financing
objectives. Interest rate swap agreements effectively convert the
underlying asset or financing from fixed to variable repricing, from
variable to fixed repricing or, in more limited circumstances, from vari-
able to variable repricing. Interest rate cap agreements effectively
establish a maximum interest rate on certain variable rate financings.
Sensitivity Analysis Methodology, Assumptions and Limitations
For its consumer lending activities, the Company uses a variety of
techniques to assess its interest rate risk exposure, one of which is
interest rate sensitivity simulation. For purposes of presenting the
possible earnings effect of a hypothetical, adverse change in inter-
est rates over the 12-month period from its fiscal year-end, the
Company assumes that all interest rate sensitive assets and liabili-
ties will be impacted by a hypothetical, immediate 100 basis point
increase in interest rates as of the beginning of the period.
Interest rate sensitive assets are assumed to be those
for which the stated interest rate is not contractually fixed for the
next 12-month period. Thus, assets which have a market-based
index, such as the prime rate, which will reset before the end of the
12-month period, or assets with rates that are fixed at fiscal year-
end, but which will mature, or otherwise contractually reset to a
market-based indexed rate prior to the end of the 12-month period,
are rate-sensitive. The latter category includes certain credit card
loans which may be offered at below-market rates for an introduc-
tory period, such as for balance transfers and special promotional
programs, after which the loans will contractually reprice in accor-
dance with the Company’s normal market-based pricing structure.
For purposes of measuring rate-sensitivity for such loans, only the
effect of the hypothetical 100 basis point change in the underlying
market-based index, such as the prime rate, has been considered
rather than the full change in the rate to which the loan would con-
tractually reprice. For assets which have a fixed rate at fiscal year-
end, but which contractually will, or are assumed to, reset to a
market-based index during the next 12 months, earnings sensitiv-
ity is measured from the expected repricing date. In addition, for all
interest rate sensitive assets, earnings sensitivity is calculated net
of expected loan losses.
Interest rate sensitive liabilities are assumed to be
those for which the stated interest rate is not contractually fixed for
the next 12-month period. Thus, liabilities which have a market-based
index, such as the prime, commercial paper, or LIBOR rates, which
will reset before the end of the 12-month period, or liabilities whose
rates are fixed at fiscal year-end, but which will mature and be
replaced with a market-based indexed rate prior to the end of the
12-month period, are rate-sensitive. For liabilities which have a
fixed rate at fiscal year-end, but which are assumed to reset to a mar-
ket-based index during the next 12 months, earnings sensitivity is
measured from the expected repricing date.
Assuming a hypothetical, immediate 100 basis point
increase in the interest rates affecting all interest rate sensitive
assets and liabilities as of November 30, 1998, pre-tax income of
consumer lending and related activities over the following 12-month
period would be reduced by approximately $65 million. The com-
parable reduction of pre-tax income for the 12-month period following
November 30, 1997 was estimated to be approximately $66 million.
The hypothetical model assumes that the balances of
interest rate sensitive assets and liabilities at fiscal year-end will
remain constant over the next 12-month period. It does not assume
any growth, strategic change in business focus, change in asset pric-
ing philosophy or change in asset/liability funding mix. Thus, this
model represents a static analysis which cannot adequately portray
how the Company would respond to significant changes in market
conditions. Furthermore, the analysis does not necessarily reflect the
Company’s expectations regarding the movement of interest rates in