US Bank 2011 Annual Report Download - page 53

Use of Derivatives to Manage Interest Rate and Other
Risks To reduce the sensitivity of earnings to interest rate,
prepayment, credit, price and foreign currency fluctuations
(“asset and liability management positions”), the Company
enters into derivative transactions. The Company uses
derivatives for asset and liability management purposes
primarily in the following ways:
• To convert fixed-rate debt from fixed-rate payments to
floating-rate payments;
• To convert the cash flows associated with floating-rate
loans and debt from floating-rate payments to fixed-rate
payments;
• To mitigate changes in value of the Company’s mortgage
origination pipeline, funded mortgage loans held for sale
and MSRs; and
• To mitigate remeasurement volatility of foreign currency
denominated balances.
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 support 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
that it enters into for risk management purposes as accounting
hedges because of the inefficiency of applying the accounting
requirements and may instead elect fair value accounting for
the related hedged items. In particular, the Company enters
into U.S. Treasury futures, options on U.S. Treasury futures
contracts, interest rate swaps and forward commitments to
buy to-be-announced securities (“TBAs”) 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 TBAs and other 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, 2011, the Company had $14.6 billion of
forward commitments to sell, hedging $6.9 billion of
mortgage loans held for sale and $12.9 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 hedging
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 where possible with its counterparties,
requiring collateral agreements with credit-rating thresholds
and, in certain cases, 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, principally
related to trading activities which support customers’ strategies
to manage their own foreign currency, interest rate risk and
funding activities. The ALCO established the Market Risk
Committee (“MRC”), which oversees market risk
management. The MRC monitors and reviews the Company’s
trading positions and establishes policies for market risk
management, including exposure limits for each portfolio. The
Company also manages market risk of non-trading business
activities, including its MSRs and certain mortgage loans held
for sale. The Company uses a Value at Risk (“VaR”) approach
to measure general market risk. Theoretically, VaR represents
the statistical risk of loss the Company has to adverse market
movements over a one-day time horizon. The Company uses
the Historical Simulation method to calculate VaR for its
trading businesses measured at the ninety-ninth percentile
using a one-year look-back period for distributions derived
from past market data. The market factors used in the
calculations include those pertinent to market risks inherent in
the underlying trading portfolios, principally those that affect
its investment grade bond trading business, foreign currency
transaction business, client derivatives business, loan trading
business and municipal securities business. On average, the
Company expects the one-day VaR to be exceeded two to
three times per year in each business. The Company monitors
the effectiveness of its risk programs by back-testing the
performance of its VaR models, regularly updating the
historical data used by the VaR models and stress testing. If the
Company were to experience market losses in excess of the
estimated VaR more often than expected, the VaR models and
associated assumptions would be analyzed and adjusted. The
Company stress tests its market risk measurements to provide
management with perspectives on market events that may not
be captured by its VaR models, including worst case historical
market movement combinations that have not necessarily
occurred on the same date.
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