US Bank 2012 Annual Report Download - page 58

behavior, and product mix. These assumptions are validated
on a periodic basis. A sensitivity analysis of key variables of
the valuation analysis is provided to the ALCO monthly and
is used to guide asset/liability management strategies.
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;
• To mitigate remeasurement volatility of foreign currency
denominated balances; and
• To mitigate the volatility of the Company’s investment in
foreign operations driven by fluctuations in foreign
currency exchange rates.
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 interest rate swaps, forward commitments to buy to-be-
announced securities (“TBAs”), U.S. Treasury futures and
options on U.S. Treasury futures to mitigate fluctuations in
the value of its MSRs, but does not designate those derivatives
as accounting hedges. The estimated net sensitivity to changes
in interest rates of the fair value of the MSRs and the related
derivative instruments at December 31, 2012, to an immediate
25, 50 and 100 bps downward movement in interest rates
would be an increase of approximately $6 million, $32
million and $103 million, respectively. An upward movement
in interest rates at December 31, 2012, of 25 and 50 bps
would increase the fair value of the MSRs and related
derivative instruments by approximately $5 million and $6
million, respectively, while a 100 bps increase would decrease
the fair value of the MSRs and related derivative instruments
by $6 million. Refer to Note 9 of the Notes to Consolidated
Financial Statements for additional information regarding
MSRs.
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, 2012, the Company had $18.5 billion of
forward commitments to sell, hedging $7.4 billion of
mortgage loans held for sale and $15.1 billion of unfunded
mortgage loan commitments. The forward commitments to
sell and the unfunded mortgage loan commitments on loans
intended to be sold are considered derivatives under the
accounting guidance related to accounting for derivative
instruments and hedging activities. 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, by entering into
master netting agreements, and, where possible by requiring
collateral agreements. The Company may also transfer
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 19 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 Company’s Market Risk
Committee (“MRC”), underneath the ALCO, 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 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
54 U.S. BANCORP