Market Risk Management
Overview
Market risk is the
risk that values of assets and liabilities or revenues will be adversely
affected by changes in market conditions such as market movements. 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 mitigation
activities, and mortgage banking activities.
Our traditional banking loan and deposit products
are nontrading positions and are reported at amortized cost for assets or the
amount owed for liabilities (historical cost). While the accounting rules
require a 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 mortgage, equity market,
commodity and issuer credit 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 Risk
Interest 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, debt securities, certain
trading-related assets and liabilities, deposits, borrowings and 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 such as options, futures, forwards and swaps.
Foreign Exchange Risk
Foreign 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, currency swaps, 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 Risk
Our 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. Fourth, we create MSRs as part of our mortgage
activities. See Note 1 and Note 8 of the Consolidated Financial Statements for
additional information on MSRs. 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, U.S. Treasury securities and mortgage-backed securities are used to
hedge mortgage risk by seeking to mitigate the effects of changes in interest
rates.
Equity Market Risk
Equity 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 hedging on a
portfolio or name basis 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 Risk
Commodity risk represents exposures we have
to products traded in the petroleum, natural gas, metals 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 Credit Risk
Our portfolio is exposed to issuer credit
risk where the value of an 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 Management
Trading-related revenues represent the amount earned from
our trading positions, which include trading account assets and liabilities, as
well as derivative positions and, prior to the conversion of the Certificates
into MSRs, market value adjustments to the Certificates and the MSRs. Trading
positions are taken in a diverse range of financial instruments and markets.
Trading account assets and liabilities, and derivative positions are reported
at fair value. MSRs are reported at lower of cost or market. For more
information on fair value, see Complex Accounting Estimates. For
additional information on MSRs, see Note 1 and Note 8 of the Consolidated Financial
Statements. Trading Account Profits represent the net amount earned from our
trading positions and, as reported in the Consolidated Statement of Income, do
not include the Net Interest Income recognized on trading positions, or the
related funding charge or benefit. 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 graphic
depiction of trading volatility and illustrates the level of trading-related
revenue for 2004. Trading-related revenue encompasses both proprietary trading
and customer-related activities. In 2004, positive trading-related revenue was
recorded for 87 percent of trading days. Furthermore, only five percent of the
total trading days had losses greater than $10 million, and the largest loss
was $27 million. This can be compared to 2003 and 2002 as follows:
- In 2003, positive trading-related revenue was
recorded for 88 percent of trading days and only four percent of total trading
days had losses greater than $10 million, and the largest loss was $41 million.
- In 2002, positive trading-related revenue was recorded for 86 percent of
trading days and only five percent of total trading days had losses greater
than $10 million, and the largest loss was $32 million.
Histogram of Daily Trading-related Revenue
Twelve Months Ended December 31, 2004
The above histogram does not include two losses greater than $50
million associated with MSRs as the losses were related to model changes rather
than market changes in the portfolio. For additional information on MSRs, see Note 1 and Note 8 of the Consolidated Financial Statements.
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. Trading 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 each year.
In addition to reviewing our underlying model
assumptions with senior management, we seek to 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.
The following graph shows actual losses did not
exceed VAR in 2004. Actual losses exceeded VAR twice during 2003.
Trading Risk and Return
Daily VAR and Trading-related Revenue
Table 26 presents average, high and low daily VAR for 2004 and 2003.
Table 26
Trading Activities Market Risk
| |
Twelve Months Ended December 31,2004: Average VAR |
Twelve Months Ended December 31,2004: High VAR(1) |
Twelve Months Ended December 31,2004: Low VAR(1) |
Twelve Months Ended December 31,2003: Average VAR |
Twelve Months Ended December 31,2003: High VAR(1) |
Twelve Months Ended December 31,2003: Low VAR(1) |
| |
Twelve Months Ended December 31 |
|  |
| |
2004 |
2003 |
| |
(Dollars in millions) |
Average
VAR |
|
|
Average
VAR |
|
|
| |
| Foreign exchange |
$ 3.6 |
$ 8.1 |
$ 1.4 |
$ 4.1 |
$ 7.8 |
$ 2.1 |
| Interest rate |
26.2 |
51.5 |
10.7 |
27.0 |
65.2 |
15.1 |
| Credit (2) |
35.7 |
61.4 |
21.9 |
20.7 |
32.6 |
14.9 |
| Real estate/mortgage (3) |
10.5 |
26.0 |
4.6 |
14.1 |
41.4 |
3.6 |
| Equities |
21.8 |
51.5 |
7.9 |
19.9 |
53.8 |
6.6 |
| Commodities |
6.5 |
10.2 |
3.8 |
8.7 |
19.3 |
4.1 |
| Portfolio diversification |
(56.3) |
- |
- |
(60.9) |
- |
- |
| Total trading portfolio |
$ 48.0 |
$ 78.5 |
$ 29.4 |
$ 33.6 |
$ 91.0 |
$ 11.2 |
|
| Total market-based trading portfolio (4) |
$ 44.1 |
$ 79.0 |
$ 23.7 |
$ 33.2 |
$ 82.0 |
$ 11.8 |
|
|
Approximately $4
million of the increase in average VAR for 2004 was attributable to the
addition of FleetBoston in the second quarter of 2004. The remaining increase
in average VAR for 2004 was primarily due to increases in the average risk
taken in credit and equities. The increase in equities was mainly due to the
increased economic risk from customer-facilitated transactions that were held
in inventory during portions of 2004. The increase in credit was mainly due to
an increase in credit protection purchased to hedge the credit risk in our
commercial credit portfolio.
Stress Testing
Because 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.
Interest Rate Risk Management
Interest 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 in 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, debt 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, with the base case
utilizing the forward market curve. 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 time horizons. The overall interest rate risk position and
strategies are reviewed on an ongoing basis with ALCO. At December 31, 2004, we
remain positioned for future rising interest rates and curve flattening to the
extent implied by the forward market curve.
The estimated impact to Net Interest Income over the
subsequent year from December 31, 2004, resulting from a 100 bp gradual (over
12 months) parallel increase or decrease in interest rates from the forward
market curve calculated as of December 31, 2004 was (1.5) percent and 0.5
percent, respectively. The estimated impact to Net Interest Income over the
subsequent year from December 31, 2003, resulting from a 100 bp gradual (over
12 months) parallel increase or decrease in interest rates from the forward
market curve calculated as of December 31, 2003, was (1.1) percent and 1.2
percent, respectively.
As part of the ALM process, we use securities, residential
mortgages, and interest rate and foreign exchange derivatives in managing
interest rate sensitivity.
Securities
The 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 our
cash and derivative positions. During 2004 and 2003, we purchased securities of
$232.6 billion and $195.9 billion, respectively, sold $105.0 billion and $171.5
billion, respectively, and received paydowns of $31.8 billion and $27.2 billion,
respectively. Not included in the purchases above were $46.7 billion of forward
purchase contracts of both mortgage-backed securities and mortgage loans at
December 31, 2004 settling from January 2005 to February 2005 with an average
yield of 5.26 percent, and $65.2 billion of forward purchase contracts of both
mortgage-backed securities and mortgage loans at December 31, 2003 that settled
from January 2004 to February 2004 with an average yield of 5.79 percent. There
were also $25.8 billion of forward sale contracts of mortgage-backed securities
at December 31, 2004 settling from January 2005 to February 2005 with an
average yield of 5.47 percent compared to $8.0 billion at December 31, 2003
that settled in February 2004 with an average yield of 6.14 percent. These
forward purchase and sale contracts were accounted for as derivatives and
designated as cash flow hedges with their net-of-tax unrealized gains and
losses included in Accumulated Other
Comprehensive Income (OCI). For additional information on derivatives
designated as cash flow hedges, see Note 4 of the Consolidated Financial
Statements. The forward purchase and sale contracts at December 31, 2004 and
2003 were also included in Table IV. During the year, we
continuously monitored the interest rate risk position of the portfolio and
repositioned the securities portfolio in order to manage prepayment risk and to
take advantage of interest rate fluctuations. Through sales in the securities
portfolio, we realized $2.1 billion and $941 million in Gains on Sales of Debt
Securities in 2004 and 2003, respectively.
Residential Mortgage Portfolio
In 2004 and 2003, we purchased $65.9 billion and $92.8
billion, respectively, of residential mortgages for our ALM portfolio and
interest rate risk management. Not included in the purchases above were $3.3 billion of forward purchase commitments
of mortgage loans at December 31, 2004 settling from January 2005 to February
2005 and $4.6 billion at December 31, 2003 that settled in January 2004. These
commitments, included in Table IV, were accounted for as
derivatives and designated as cash flow hedges, and their net-of-tax unrealized
gains and losses were included in Accumulated OCI. During 2004, there were no
sales of whole mortgage loans. In 2003, we sold $27.5 billion of whole mortgage
loans and recognized $772 million in gains on the sales included in Other
Noninterest Income. Additionally, during the same periods, we received paydowns
of $44.4 billion and $62.8 billion, respectively.
Interest Rate
and Foreign Exchange Derivative Contracts
Interest 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 4 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 currency-denominated assets and
liabilities, as well as our equity investments in foreign subsidiaries.
Table IV 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, 2004 and 2003.
Consistent with our strategy of managing
interest rate sensitivity to mitigate changes in value of other financial
instruments, the notional amount of our net received fixed interest rate swap
position decreased $11.7 billion to $9.5 billion at December 31, 2004 compared
to December 31, 2003. The net option position increased $238.9 billion to
$323.8 billion at December 31, 2004 compared to December 31, 2003 to offset
interest rate risk in other portfolios. The changes in our swap and option
positions were part of our interest sensitivity management.
Mortgage Banking Risk Management
We manage changes in the value of MSRs by entering into derivative
financial instruments and by purchasing and selling securities. MSRs are assets created when the underlying
mortgage loan is sold to investors and we retain the right to service the loan.
As of December 31, 2004, the MSR balance was $2.5 billion, or 10 percent lower
than December 31, 2003.
We designate certain
derivatives such as purchased options and interest rate swaps as fair value
hedges of specified MSRs under SFAS 133. At December 31, 2004, the amount of
MSRs identified as being hedged by derivatives in accordance with SFAS 133 was
approximately $1.8 billion. The notional amount of the derivative
contracts designated as SFAS 133 hedges of MSRs at December 31, 2004 was $18.5
billion. The changes in the fair values of the derivative contracts are
substantially offset by changes in the fair values of the MSRs that are hedged
by these derivative contracts. During
2004, derivative hedge gains of $228 million were offset by a decrease in the
value of the MSRs of $210 million resulting in $18 million of hedge
ineffectiveness.
From time to time, we hold
additional derivatives and certain securities (i.e. mortgage-backed securities) as economic hedges of MSRs, which are not designated as SFAS 133
accounting hedges. During 2004,
Gains on Sales of Debt Securities of $117 million and $65 million of Interest
Income from Securities used as an economic hedge of MSRs were realized. At December 31, 2004, the amount of MSRs
covered by such economic hedges was $564 million. The carrying value of
AFS Securities held as economic hedges of MSRs was $1.9 billion at December 31,
2004. The related net-of-tax unrealized gain on these AFS Securities, which is
recorded in Accumulated OCI, was $13 million at December 31, 2004.
See Note 1 and Note 8 of the
Consolidated Financial Statements for additional information.
|
