US Bank 2009 Annual Report Download - page 53

derivatives for asset and liability management purposes
primarily in the following ways:
• To convert fixed-rate debt, issued to finance the Company,
from fixed-rate payments to floating-rate payments;
• To convert the cash flows associated with floating-rate
debt, issued to finance the Company, from floating-rate
payments to fixed-rate payments; and
• To mitigate changes in value of the Company’s mortgage
origination pipeline, mortgage loans held for sale and
MSRs.
To manage these risks, the Company may enter into
exchange-traded and over-the-counter derivative contracts,
including interest rate swaps, swaptions, futures, forwards
and options. In addition, the Company enters into interest
rate and foreign exchange derivative contracts to
accommodate the business requirements of its customers
(“customer-related positions”). The Company minimizes the
market and liquidity risks of customer-related positions by
entering into similar offsetting positions with broker-dealers.
The Company does not utilize derivatives for speculative
purposes.
The Company does not designate all of the derivatives it
enters into for risk management purposes as accounting
hedges because of the inefficiency of applying the accounting
requirements. In particular, the Company enters into
U.S. Treasury futures, options on U.S. Treasury futures
contracts and forward commitments to buy residential
mortgage loans to mitigate fluctuations in the value of its
MSRs, but does not designate those derivatives as
accounting hedges.
Additionally, the Company uses forward commitments
to sell residential mortgage loans at specified prices to
economically hedge the interest rate risk in its residential
mortgage loan production activities. At December 31, 2009,
the Company had $8.3 billion of forward commitments to
sell mortgage loans hedging $4.3 billion of mortgage loans
held for sale and $5.7 billion of unfunded mortgage loan
commitments. The forward commitments to sell and the
unfunded mortgage loan commitments are considered
derivatives under the accounting guidance related to
accounting for derivative instruments and hedge activities,
and the Company has elected the fair value option for the
mortgage loans held for sale.
Derivatives are subject to credit risk associated with
counterparties to the contracts. Credit risk associated with
derivatives is measured by the Company based on the
probability of counterparty default. The Company manages
the credit risk of its derivative positions by diversifying its
positions among various counterparties, entering into master
netting agreements with its counterparties, requiring
collateral agreements with credit-rating thresholds and, in
certain cases, though insignificant, transferring the
counterparty credit risk related to interest rate swaps to
third-parties through the use of risk participation
agreements.
For additional information on derivatives and hedging
activities, refer to Note 20 in the Notes to Consolidated
Financial Statements.
Market Risk Management In addition to interest rate risk,
the Company is exposed to other forms of market risk as a
consequence of conducting normal trading activities. These
trading activities principally support the risk management
processes of the Company’s customers, including their
management of foreign currency, interest rate risks and
funding activities. The Company also manages market risk
of non-trading business activities, including its MSRs and
loans held-for-sale. The Company uses a Value at Risk
(“VaR”) approach to measure general market risk.
Theoretically, VaR represents the amount the Company has
at risk of loss to adverse market movements over a specified
time horizon. The Company measures VaR at the ninety-
ninth percentile using distributions derived from past market
data. On average, the Company expects the one day VaR to
be exceeded two to three times per year. The Company
monitors the effectiveness of its risk program by back-testing
the performance of its VaR models, regularly updating the
historical data used by the VaR models and stress testing. As
part of its market risk management approach, the Company
sets and monitors VaR limits for each trading portfolio. The
Company’s trading VaR did not exceed $4 million during
2009 and $1 million during 2008.
Liquidity Risk Management The ALCO establishes policies
and guidelines, as well as analyzes and manages liquidity, to
ensure that adequate funds are available to meet normal
operating requirements in addition to unexpected customer
demands for funds, such as high levels of deposit
withdrawals or loan demand, in a timely and cost-effective
manner. The most important factor in the preservation of
liquidity is maintaining public confidence that facilitates the
retention and growth of a large, stable supply of core
deposits and wholesale funds.
During 2008 and 2009, the financial markets were
challenging for many financial institutions. As a result of
these financial market conditions, many banks experienced
liquidity constraints, substantially increased pricing to retain
deposits or utilized the Federal Reserve System discount
U.S. BANCORP 51