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2003 Annual Report: Financial Review:
Management's Discussion and Analysis: Market Risk Management
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Market Risk Management |
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Market risk is the potential loss due to adverse changes in the market value or yield of a position. This risk is inherent in the financial instruments associated with our operations and/or activities including loans, deposits, securities, short-term borrowings, long-term debt, trading account assets and liabilities, and derivatives. Market-sensitive assets and liabilities are generated through loans and deposits associated with our traditional banking business, our customer and proprietary trading operations, our ALM process, credit risk management, and mortgage banking activities. Our traditional banking loan and deposit products are nontrading positions and are not reported at market value but instead are reported at amortized cost for assets or the amount owed for liabilities (historical cost). While the accounting rules require an historical cost view of traditional banking assets and liabilities, these positions are still subject to changes in economic value based on varying market conditions. Interest rate risk is the effect of changes in the economic value of our loans and deposits, as well as our other interest rate sensitive instruments, and is reflected in the levels of future income and expense produced by these positions versus levels that would be generated by current levels of interest rates. We seek to mitigate interest rate risk as part of the ALM process. We seek to mitigate trading risk within our prescribed risk appetite using hedging techniques. Trading positions are reported at estimated market value with changes reflected in income. Trading positions are subject to various risk factors, which include exposures to interest rates and foreign exchange rates, as well as equity, mortgage, commodity and issuer risk factors. We seek to mitigate these risk exposures by utilizing a variety of financial instruments. The following discusses the key risk components along with respective risk mitigation techniques. Interest Rate RiskInterest rate risk represents exposures we have to instruments whose values vary with the level of interest rates. These instruments include, but are not limited to, loans, deposits, bonds, futures, forwards, options and other derivative instruments. We seek to mitigate risks associated with the exposures in a variety of ways that typically involve taking offsetting positions in cash or derivative markets. The cash and derivative instruments allow us to seek to mitigate risks by reducing the effect of movements in the level of interest rates, changes in the shape of the yield curve as well as changes in interest rate volatility. Hedging instruments used to mitigate these risks include related derivatives - options, futures, forwards, swaps, swaptions, and caps and floors.Foreign Exchange RiskForeign exchange risk represents exposures we have to changes in the values of current holdings and future cash flows denominated in other currencies. The types of instruments exposed to this risk include investments in foreign subsidiaries, foreign currency-denominated loans, foreign currency-denominated securities, future cash flows in foreign currencies arising from foreign exchange transactions, and various foreign exchange derivative instruments whose values fluctuate with changes in currency exchange rates or foreign interest rates. Instruments used to mitigate this risk are foreign exchange options, futures, forwards and deposits. These instruments help insulate us against losses that may arise due to volatile movements in foreign exchange rates or interest rates.Mortgage RiskOur exposure to mortgage risk takes several forms. First, we trade and engage in market-making activities in a variety of mortgage securities, including whole loans, pass-through certificates, commercial mortgages, and collateralized mortgage obligations. Second, we originate a variety of asset-backed securities, which involves the accumulation of mortgage-related loans in anticipation of eventual securitization. Third, we may hold positions in mortgage securities and residential mortgage loans as part of the ALM portfolio. These activities generate market risk since these instruments are sensitive to changes in the level of market interest rates, changes in mortgage prepayments and interest rate volatility. Options, futures, forwards, swaps, swaptions and U.S. Treasury securities are used to hedge mortgage risk by seeking to mitigate the effects of changes in interest rates.Equity Market RiskEquity market risk arises from exposure to securities that represent an ownership interest in a corporation in the form of common stock or other equity-linked instruments. The instruments held that would lead to this exposure include, but are not limited to, the following: common stock, listed equity options (puts and calls), over-the-counter equity options, equity total return swaps, equity index futures and convertible bonds. We seek to mitigate the risk associated with these securities via portfolio hedging that focuses on reducing volatility from changes in stock prices. Instruments used for risk mitigation include options, futures, swaps, convertible bonds and cash positions.Commodity RiskCommodity risk represents exposures we have to products traded in the petroleum, natural gas and power markets. Our principal exposure to these markets emanates from customer-driven transactions. These transactions consist primarily of futures, forwards, swaps and options. We seek to mitigate exposure to the commodity markets with instruments including, but not limited to, options, futures and swaps in the same or similar commodity product, as well as cash positions.Issuer RiskOur trading portfolio is exposed to issuer risk where the value of a trading account asset may be adversely impacted for various reasons directly related to the issuer, such as management performance, financial leverage or reduced demand for the issuer's goods or services. Perceived changes in the creditworthiness of a particular debtor or sector can have significant effects on the replacement costs of both cash and derivative positions. We seek to mitigate the impact of credit spreads, credit migration and default risks on the market value of the trading portfolio with the use of credit default swaps, and credit fixed income and similar securities.Trading Risk ManagementTrading-related revenues represent the amount earned from our trading positions, which include trading account assets and liabilities, derivative positions and mortgage banking assets. Trading positions are taken in a diverse range of financial instruments and markets, and are reported at fair value. For more information on fair value, see Complex Accounting Estimates and Principles. Trading account profits can be volatile and are largely driven by general market conditions and customer demand. Trading account profits are dependent on the volume and type of transactions, the level of risk assumed, and the volatility of price and rate movements at any given time within the ever-changing market environment.The histogram of daily revenue or loss below is a simple graphic depicting trading volatility and tracking success of trading-related revenue for 2003. Trading-related revenue encompasses both proprietary trading and customer-related activities. In 2003, positive trading-related revenue was recorded for 88 percent of trading days. Furthermore, only four percent of the total trading days had losses greater than $10 million, and the largest loss was $41 million. This can be compared to 2002 and 2001 as follows:
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Histogram of Daily Trading-related Revenue |
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To evaluate risk in our trading activities, we focus on the actual and potential volatility of individual positions as well as portfolios. At a portfolio and corporate level, we use Value-at-Risk (VAR) modeling and stress testing. VAR is a key statistic used to measure and manage market risk. Trader limits and VAR are used to manage day-to-day risks and are subject to testing where we compare expected performance to actual performance. This testing provides us a view of our models' predictive accuracy. All limit excesses are communicated to senior management for review. A VAR model estimates a range of hypothetical scenarios within which the next day's profit or loss is expected. These estimates are impacted by the nature of the positions in the portfolio and the correlation within the portfolio. Within any VAR model, there are significant and numerous assumptions that will differ from company to company. Our VAR model assumes a 99 percent confidence level. Statistically this means that losses will exceed VAR, on average, one out of 100 trading days, or two to three times a year. Actual losses exceeded VAR twice in 2003, did not exceed VAR in 2002 and exceeded VAR once in 2001. There are numerous assumptions and estimates associated with modeling, and actual results could differ. In addition to reviewing our underlying model assumptions with senior management, we mitigate the uncertainties related to these assumptions and estimates through close monitoring and by updating the assumptions and estimates on an ongoing basis. If the results of our analysis indicate higher than expected levels of risk, proactive measures are taken to adjust risk levels. Table 18 presents average, high and low daily VAR for both 2003 and 2002. |
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During the fourth quarter of 2002, we completed an enhancement of our methodology used in the VAR risk aggregation calculation. This approach utilizes historical market conditions over the last three years to derive estimates of trading risk and provides the ability to aggregate trading risk across different businesses. Historically, we used a mathematical method to allocate risk across different trading businesses that did not assume the benefit of diversification across markets. This change resulted in a lower VAR calculation starting in the fourth quarter 2002. The reduction in average VAR for 2003 was primarily due to the 2002 methodology enhancements and the $5 million decline in real estate/mortgages, partially offset by increases in equities of $11 million. The increase in equities was mainly due to the increased economic risk from customer-facilitated business that was held in inventory throughout the first three quarters of 2003 and sold during the fourth quarter 2003. The large increase in the interest rate and total trading portfolio high VAR was due to activities on one day during the period. The next highest VAR for interest rates and total trading portfolio was $47.4 million and $61.2 million, respectively, during 2003. Stress TestingBecause the very nature of a VAR model suggests results can exceed our estimates, we "stress test" our portfolio. Stress testing estimates the value change in our trading portfolio due to abnormal market movements. Various stress scenarios are run regularly against the trading portfolio to verify that, even under extreme market moves, we will preserve our capital; to determine the effects of significant historical events; and to determine the effects of specific, extreme hypothetical, but plausible events. The results of the stress scenarios are calculated daily and reported to senior management as part of the regular reporting process. The results of certain specific, extreme hypothetical scenarios are presented to ALCO.In addition, each business has established risk concentration limits with the goal of ensuring the amount of risk taken within each business is consistent with the risk appetite for that business. Each business is independently monitored to assure adherence to approved risk measures, limits and controls. The primary risk mitigation tool involves monitoring exposures relative to concentration, balance sheet, notional and derivative limits. Interest Rate Risk ManagementInterest rate risk represents the most significant market risk exposure to our nontrading financial instruments. Our overall goal is to manage interest rate sensitivity so that movements in interest rates do not adversely affect net interest income. Interest rate risk is measured as the potential volatility to our net interest income caused by changes in market interest rates. Client facing activities, primarily lending and deposit-taking, create interest rate sensitive positions on our balance sheet. Interest rate risk from these activities as well as the impact of ever-changing market conditions, is mitigated using the ALM process.Sensitivity simulations are used to estimate the impact on net interest income of numerous interest rate scenarios, balance sheet trends and strategies. These simulations estimate levels of short-term financial instruments, securities, loans, deposits, borrowings and derivative instruments. In addition, these simulations incorporate assumptions about balance sheet dynamics such as loan and deposit growth and pricing, changes in funding mix, and asset and liability repricing and maturity characteristics. In addition to net interest income sensitivity simulations, market value sensitivity measures are also utilized. The Balance Sheet Management group maintains a net interest income forecast utilizing different rate scenarios, including a most likely scenario, which is designed around an economic forecast that is meant to estimate our expectation of the most likely path of rates for the upcoming horizon. The Balance Sheet Management group constantly updates the net interest income forecast for changing assumptions and differing outlooks based on economic trends and market conditions. The Balance Sheet Management group reviews the impact on net interest income of parallel and nonparallel shifts in the yield curve over different horizons. The overall interest rate risk position and strategies are reviewed on an ongoing basis with ALCO. At December 31, 2003, we were positioned to benefit from rising long-term interest rates, with short-term interest rates being stable. Table 19 provides our estimated net interest income at risk over the subsequent year from December 31, 2003 and 2002, resulting from a 100 bp gradual (over 12 months) increase or decrease in interest rates from the forward curve calculated as of December 31, 2003 and 2002, respectively. Beginning in the third quarter 2003, these shocks were applied to the forward interest rate curve implied by the financial markets. Previously, these shocks were applied to current interest rates held stable. This change more closely aligns these risk measures with management's view of this risk. The prior period has been restated to conform to the current methodology.
As part of the ALM process, we use securities, residential mortgages, and interest rate and foreign exchange derivatives in managing interest rate sensitivity. SecuritiesThe securities portfolio is integral to our ALM process. The decision to purchase or sell securities is based upon the current assessment of economic and financial conditions, including the interest rate environment, liquidity and regulatory requirements, and the relative mix of cash and derivative positions. In 2003 and 2002, we purchased securities of $195.9 billion and $146.0 billion, respectively, sold $171.5 billion and $137.1 billion, respectively and received paydowns of $27.2 billion and $25.0 billion, respectively. Not included in the purchases above were $65.2 billion of forward purchase contracts of both mortgage-backed securities and mortgage loans at December 31, 2003 settling from January 2004 to February 2004 with an average yield of 5.79 percent, and $3.5 billion of forward purchase contracts of both mortgage-backed securities and mortgage loans at December 31, 2002 settling in January 2003 with an average yield of 5.91 percent. These forward purchase contracts, included in Table 20, were accounted for as derivatives and their net-of- tax unrealized gains and losses were included in accumulated other comprehensive income (OCI). The pre-tax unrealized gain on these forward purchase contracts at December 31, 2003 and 2002 was $1.9 billion and $58 million, respectively. There were also $8.0 billion of forward sale contracts of mortgage-backed securities at December 31, 2003 settling in February 2004 with an average yield of 6.14 percent, and $19.7 billion of forward sale contracts of mortgage-backed securities at December 31, 2002 settling in January and February 2003 with an average yield of 6.05 percent. These forward sale contracts, included in Table 20, were accounted for as derivatives and their net-of-tax unrealized gains and losses were included in accumulated OCI. The pre-tax unrealized gain on these forward sale contracts at December 31, 2003 was $22 million compared to a pre-tax unrealized loss of $189 million at December 31, 2002. During the year, we continuously monitored the interest rate risk position of the portfolio and repositioned the securities portfolio in order to mitigate risk and to take advantage of interest rate fluctuations. Through sales in the securities portfolio, we realized $941 million and $630 million in gains on sales of debt securities during 2003 and 2002, respectively.Residential Mortgage PortfolioWe repositioned the ALM mortgage loan portfolio to mitigate prepayment risk resulting from the unusually low rate environment. The residential mortgages, a component of our ALM strategy, grew primarily through whole loan purchase activity. In 2003 and 2002, we purchased $92.8 billion and $55.0 billion, respectively, of residential mortgages in the wholesale market for our ALM portfolio and interest rate risk management. Not included in the purchases above were $4.6 billion of forward purchase commitments of mortgage loans at December 31, 2003 settling in January 2004. These commitments, included in Table 20, were accounted for as derivatives at December 31, 2003 under the provisions of SFAS No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" (SFAS 149) and their net-of-tax unrealized gains and losses were included in accumulated OCI. The pre-tax unrealized gain on these forward purchase commitments at December 31, 2003 was $10 million. During 2003 and 2002, we sold $27.5 billion and $22.7 billion, respectively, of whole mortgage loans and recognized $772 million and $500 million, respectively, in gains on the sales included in other noninterest income. Additionally, during the same periods we received paydowns of $62.8 billion and $36.9 billion, respectively.Interest Rate and Foreign Exchange Derivative ContractsInterest rate and foreign exchange derivative contracts are utilized in our ALM process and serve as an efficient, low-cost tool to mitigate our risk. We use derivatives to hedge or offset the changes in cash flows or market values of our balance sheet. See Note 6 of the consolidated financial statements for additional information on our hedging activities.Our interest rate contracts are generally nonleveraged generic interest rate and basis swaps, options, futures and forwards. In addition, we use foreign currency contracts to mitigate the foreign exchange risk associated with foreign-denominated assets and liabilities, as well as our equity investments in foreign subsidiaries. Table 20 reflects the notional amounts, fair value, weighted average receive fixed and pay fixed rates, expected maturity and estimated duration of our ALM derivatives at December 31, 2003 and 2002. |
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Consistent with our strategy of managing interest rate sensitivity, the notional amount of our net received fixed interest rate swap position decreased $33.6 billion to $21.2 billion at December 31, 2003 compared to December 31, 2002 to mitigate changes in value of other financial instruments. The net option position increased $36.6 billion to $85.0 billion at December 31, 2003 compared to December 31, 2002 to offset interest rate risk in other portfolios. This increase occurred throughout 2003. Mortgage Banking Risk ManagementMortgage production activities create unique interest rate and prepayment risk. Interest rate risk occurs between the loan commitment date (pipeline) and the date the loan is sold to the secondary market. To mitigate interest rate risk, we enter into various financial instruments including interest rate swaps, forward delivery contracts, Eurodollar futures and option contracts. The notional amount of such contracts was $13.1 billion at December 31, 2003 with associated net unrealized losses of $42 million. At December 31, 2002, the notional amount of such contracts was $25.3 billion with associated net unrealized losses of $224 million. Of these net unrealized losses, $27 million and $140 million, respectively, were recorded in accumulated OCI. These unrealized losses at December 31, 2003 and 2002 were offset by economic gains in the warehouse that will be recognized upon delivery to the secondary market.Prepayment risk represents the loss in value associated with a high rate loan paying off in a low rate environment and the loss of servicing value when loans prepay. We mitigate prepayment risk using various financial instruments including purchased options and swaps. The notional amounts of such contracts at December 31, 2003 and 2002 were $64.2 billion and $53.1 billion, respectively. The related unrealized loss was $328 million at December 31, 2003 compared to an unrealized gain of $955 million at December 31, 2002. These amounts are included in the Derivatives table in Note 6 of the consolidated financial statements. See Note 1 of the consolidated financial statements for additional discussion of these financial instruments in the mortgage banking assets section. |
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