Bank of America 2009 Annual Report Download - page 134

Derivatives and Hedging Activities
Derivatives are held on behalf of customers, for trading, as economic
hedges, or as qualifying accounting hedges, with the determination made
when the Corporation enters into the derivative contract. The designation
may change based upon management’s reassessment or changing cir-
cumstances. Derivatives utilized by the Corporation include swaps, finan-
cial futures and forward settlement contracts, and option contracts. A
swap agreement is a contract between two parties to exchange cash
flows based on specified underlying notional amounts, assets and/or
indices. Financial futures and forward settlement contracts are agree-
ments to buy or sell a quantity of a financial instrument, index, currency
or commodity at a predetermined future date, and rate or price. An option
contract is an agreement that conveys to the purchaser the right, but not
the obligation, to buy or sell a quantity of a financial instrument (including
another derivative financial instrument), index, currency or commodity at a
predetermined rate or price during a period or at a date in the future.
Option agreements can be transacted on organized exchanges or directly
between parties.
All derivatives are recorded on the Consolidated Balance Sheet at fair
value, taking into consideration the effects of legally enforceable master
netting agreements that allow the Corporation to settle positive and neg-
ative positions and offset cash collateral held with the same counterparty
on a net basis. For exchange-traded contracts, fair value is based on
quoted market prices. For non-exchange traded contracts, fair value is
based on dealer quotes, pricing models, discounted cash flow method-
ologies, or similar techniques for which the determination of fair value
may require significant management judgment or estimation.
Valuations of derivative assets and liabilities reflect the value of the
instrument including counterparty credit risk. These values also take into
account the Corporation’s own credit standing, thus including in the valu-
ation of the derivative instrument the value of the net credit differential
between the counterparties to the derivative contract.
Trading Derivatives and Economic Hedges
Derivatives held for trading purposes are included in derivative assets or
derivative liabilities with changes in fair value included in trading account
profits (losses).
Derivatives used as economic hedges are also included in derivative
assets or derivative liabilities. Changes in the fair value of derivatives that
serve as economic hedges of mortgage servicing rights (MSRs), interest
rate lock commitments (IRLCs) and first mortgage loans held-for-sale
(LHFS) that are originated by the Corporation are recorded in mortgage
banking income. Changes in the fair value of derivatives that serve as
asset and liability management (ALM) economic hedges that do not qual-
ify or were not designated as accounting hedges are recorded in other
income (loss). Credit derivatives used by the Corporation as economic
hedges do not qualify as accounting hedges despite being effective eco-
nomic hedges, and changes in the fair value of these derivatives are
included in other income (loss).
Derivatives Used For Hedge Accounting Purposes (Accounting
Hedges)
For accounting hedges, the Corporation formally documents at inception
all relationships between hedging instruments and hedged items, as well
as the risk management objectives and strategies for undertaking various
accounting hedges. Additionally, the Corporation uses dollar offset or
regression analysis at the inception of a hedge and for each reporting
period thereafter to assess whether the derivative used in its hedging
transaction is expected to be and has been highly effective in offsetting
changes in the fair value or cash flows of a hedged item. The Corporation
discontinues hedge accounting when it is determined that a derivative is
not expected to be or has ceased to be highly effective as a hedge, and
then reflects changes in fair value of the derivative in earnings after
termination of the hedge relationship.
The Corporation uses its accounting hedges as either fair value hedg-
es, cash flow hedges or hedges of net investments in foreign operations.
The Corporation manages interest rate and foreign currency exchange
rate sensitivity predominantly through the use of derivatives. Fair value
hedges are used to protect against changes in the fair value of the Corpo-
ration’s assets and liabilities that are due to interest rate or foreign
exchange volatility. Cash flow hedges are used primarily to minimize the
variability in cash flows of assets or liabilities, or forecasted transactions
caused by interest rate or foreign exchange fluctuations. For terminated
cash flow hedges, the maximum length of time over which forecasted
transactions are hedged is 26 years, with a substantial portion of the
hedged transactions being less than 10 years. For open or future cash
flow hedges, the maximum length of time over which forecasted trans-
actions are or will be hedged is less than seven years.
Changes in the fair value of derivatives designated as fair value
hedges are recorded in earnings, together and in the same income
statement line item with changes in the fair value of the related hedged
item. Changes in the fair value of derivatives designated as cash flow
hedges are recorded in accumulated OCI and are reclassified into the line
item in the income statement in which the hedged item is recorded and in
the same period the hedged item affects earnings. Hedge ineffectiveness
and gains and losses on the excluded component of a derivative in
assessing hedge effectiveness are recorded in earnings in the same
income statement line item. The Corporation records changes in the fair
value of derivatives used as hedges of the net investment in foreign
operations, to the extent effective, as a component of accumulated OCI.
If a derivative instrument in a fair value hedge is terminated or the
hedge designation removed, the previous adjustments to the carrying
amount of the hedged asset or liability are subsequently accounted for in
the same manner as other components of the carrying amount of that
asset or liability. For interest-earning assets and interest-bearing
liabilities, such adjustments are amortized to earnings over the remaining
life of the respective asset or liability. If a derivative instrument in a cash
flow hedge is terminated or the hedge designation is removed, related
amounts in accumulated OCI are reclassified into earnings in the same
period or periods during which the hedged forecasted transaction affects
earnings. If it is probable that a forecasted transaction will not occur, any
related amounts in accumulated OCI are reclassified into earnings in that
period.
Interest Rate Lock Commitments
The Corporation enters into IRLCs in connection with its mortgage bank-
ing activities to fund residential mortgage loans at specified times in the
future. IRLCs that relate to the origination of mortgage loans that will be
held for sale are considered derivative instruments under applicable
accounting guidance. As such, these IRLCs are recorded at fair value with
changes in fair value recorded in mortgage banking income.
Effective January 1, 2008, the Corporation adopted new accounting
guidance that requires that the expected net future cash flows related to
servicing of a loan be included in the measurement of all written loan
commitments accounted for at fair value through earnings. In estimating
the fair value of an IRLC, the Corporation assigns a probability to the loan
commitment based on an expectation that it will be exercised and the
loan will be funded. The fair value of the commitments is derived from the
fair value of related mortgage loans which is based on observable market
data. Changes to the fair value of IRLCs are recognized based on interest
rate changes, changes in the probability that the commitment will be
exercised and the passage of time. Changes from the expected future
132 Bank of America 2009