US Bank 2015 Annual Report Download - page 62

Use of Derivatives to Manage Interest Rate and Other
Risks To manage the sensitivity of earnings and capital 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 MLHFS and MSRs;
– To mitigate remeasurement volatility of foreign currency
denominated balances; and
– To mitigate the volatility of the Company’s investment in
foreign businesses driven by fluctuations in foreign currency
exchange rates.
The Company may enter into derivative contracts that are
either exchange-traded, centrally cleared through
clearinghouses or over-the-counter. 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 either entering into similar offsetting positions
with broker-dealers, or on a portfolio basis by entering into
other derivative or non-derivative financial instruments that
partially or fully offset the exposure from these customer-
related positions. 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 and Eurodollar
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,
2015, to an immediate 25, 50 and 100 bps downward
movement in interest rates would be a decrease of
approximately $7 million, $24 million and $123 million,
respectively. An immediate upward movement in interest rates
at December 31, 2015 of 25, 50 and 100 bps would
decrease the fair value of the MSRs and related derivative
instruments by $2 million, $16 million and $33 million,
respectively. Refer to Note 10 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, 2015, the Company had $5.4 billion of
forward commitments to sell, hedging $2.1 billion of MLHFS
and $4.1 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 MLHFS.
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 arrangements, and, where possible by
requiring collateral arrangements. The Company may also
transfer counterparty credit risk related to interest rate swaps
to third parties through the use of risk participation
agreements. In addition, certain interest rate swaps and
forwards and credit contracts are required to be centrally
cleared through clearinghouses to further mitigate
counterparty credit risk.
For additional information on derivatives and hedging
activities, refer to Notes 20 and 21 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. For purposes of its
internal capital adequacy assessment process, the Company
considers risk arising from its trading activities employing
methodologies consistent with the requirements of regulatory
rules for market risk. The Company’s Market Risk Committee
(“MRC”), within the framework of 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
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