eTrade 2003 Annual Report Download - page 49

Table of Contents
Index to Financial Statements
liability structure consists primarily of transactional deposit relationships, such as money market accounts, shorter-term certificates of deposit
and wholesale collateralized borrowings from the FHLB and other entities. The derivative portfolio of the Bank is positioned to decrease the
overall market risk resulting from the combination of assets and liabilities. The Bank’s market risk is discussed and quantified in more detail in
the Scenario Analysis section below.
Most of the Bank’s assets are generally classified as non-trading portfolios and, as such, are not marked-to-market through earnings for
accounting purposes. The Bank did maintain a trading portfolio of investment-grade securities throughout 2002 and 2003. The fair value of the
trading portfolio was $821 million and $392 million at December 31, 2003 and 2002, respectively.
Scenario Analysis
Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Net Present Value of Equity (“NPVE”)
approach, the present value of all existing assets, liabilities, derivatives and forward commitments are estimated and then combined to produce
a NPVE figure. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which
include, but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 basis points. The down 200 and 300
basis point scenarios are not presented at December 31, 2003 and 2002, because they result in negative interest rates. The sensitivity of NPVE
at December 31, 2003 and 2002 and the limits established by the Bank’s Board of Directors are listed below (dollars in thousands):
Under criteria published by the OTS, the Bank’s overall interest rate risk exposure at December 31, 2003 is characterized as “minimal.”
Derivative Financial Instruments
Change in Net Present Value of Equity
At December 31,
Board Limit
Parallel Change in Interest Rates (bps) 2003 2002
+300
$
(278,901
)
(26)%
$
(240,693
)
(29)%
(55
)%
+200
$
(175,696
)
(16)%
$
(149,554
)
(18)%
(30
)%
+100
$
(76,145
)
(7)%
$
(57,255
)
(7)%
(15
)%
-
100
$
18,418
2%
$
(19,354
)
(2)%
(15
)%
The Bank uses derivative financial instruments to help manage its interest rate risk. Interest rate swaps are used to lower the duration of
specific fixed-rate assets or increase the duration of specific adjustable-rate liabilities. Interest rate swaps involve the exchange of fixed-rate
and variable-rate interest payments between two parties based on a contractual underlying notional amount, but do not involve the exchange of
the underlying notional amounts. Option products are utilized primarily to decrease the market value changes resulting from the prepayment
dynamics of the Bank’s mortgage portfolios, as well as to protect against increases in funding costs. The types of options the Bank employs are
primarily Cap Options (“Caps”) and Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps mitigate the market risk
associated with increases in interest rates, while Floors mitigate the risk associated with decreases in market interest rates. Similarly, Payor and
Receiver Swaptions mitigate the market risk associated with the respective increases and decreases in interest rates.
Mortgage Production Activities
In the production of mortgage products, the Bank is exposed to interest rate risk between the commitment and funding dates of the loans.
There were $0.3 billion at December 31, 2003 and $1.1 billion at December 31, 2002, in mortgage loan commitments awaiting funding. The
associated interest rate risk results when the Bank enters into Interest Rate Lock Commitments (“IRLCs”), whereby determination of loan
interest rates occurs prior to funding. When the intent is to sell originated loans, the associated IRLCs are considered derivatives and,
accordingly, are recorded at fair value with associated changes recorded in earnings.
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