Capital One 1998 Annual Report Download - page 45

43 Capital One Financial Corporation
liabilities or off-balance sheet items. The Company enters into for-
ward foreign currency exchange contracts (“f/x contracts”) and cur-
rency swaps to reduce its sensitivity to changing foreign currency
exchange rates. All of the Company’s f/x contracts and currency
swaps are designated and effective as hedges of specific assets or
liabilities. The Company does not hold or issue derivative financial
instruments for trading purposes.
Swap agreements involve the periodic exchange of payments
over the life of the agreements. Amounts paid or received on inter-
est rate and currency swaps are recorded on an accrual basis as an
adjustment to the related income or expense of the item to which
the agreements are designated. As of December 31, 1998, the
related amount payable to counterparties was $2,463. As of
December 31, 1997, the related amount receivable from counter-
parties was $2,771. Changes in the fair value of interest rate swaps
are not reflected in the accompanying financial statements, where
designated to existing or anticipated assets, liabilities or off-bal-
ance sheet items and where swaps effectively modify or reduce
interest rate sensitivity.
F/x contracts represent an agreement to exchange a specified
notional amount of two different currencies at a specified exchange
rate on a specified future date. Changes in the fair value of f/x con-
tracts and currency swaps are recorded in the period in which they
occur as foreign currency gains or losses in other non-interest
income, effectively offsetting the related gains or losses on the
items to which they are designated.
Realized and unrealized gains or losses at the time of maturity,
termination, sale or repayment of a derivative contract are recorded
in a manner consistent with its original designation. Amounts are
deferred and amortized as an adjustment to the related income or
expense over the original period of exposure, provided the desig-
nated asset, liability or off-balance sheet item continues to exist, or
in the case of anticipated transactions, is probable of occurring.
Realized and unrealized changes in the fair value of swaps or f/x
contracts, designated with items that no longer exist or are no
longer probable of occurring, are recorded as a component of the
gain or loss arising from the disposition of the designated item.
Interest rate and foreign currency exchange rate risk manage-
ment contracts are generally expressed in notional principal or
contract amounts that are much larger than the amounts potentially
at risk for nonperformance by counterparties. In the event of non-
performance by the counterparties, the Company’s credit exposure
on derivative financial instruments is limited to the value of the
contracts that have become favorable to the Company. The
Company actively monitors the credit ratings of its counterparties.
Under the terms of certain swaps, each party may be required
to pledge collateral if the market value of the swaps exceeds an
amount set forth in the agreement or in the event of a change in its
credit rating.
Securitizations
The Company records gains or losses on the securitization of con-
sumer loan receivables on the date of sale based on the estimated
fair value of assets sold and retained and liabilities incurred in the
sale. Gains represent the present value of estimated cash flows the
Company has retained over the estimated outstanding period of the
receivables. This excess cash flow essentially represents an “inter-
est only”(“I/O”) strip, consisting of the excess of finance charges
and past-due fees over the sum of the return paid to certificatehold-
ers, estimated contractual servicing fees and credit losses. The I/O
strip is carried at fair value, with changes in the fair value reported
as a component of cumulative other comprehensive income. Cer-
tain estimates inherent in the determination of the fair value of
the I/O strip are influenced by factors outside the Company’s
control, and as a result, such estimates could materially change
in the near term. The gains on securitizations and other income
from securitizations are included in servicing and securitizations
income.
In June 1996, the Financial Accounting Standards Board
(“FASB”) issued Statement of Financial Accounting Standards
(“SFAS”) No. 125, “Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities”(“SFAS 125”),
which was effective January 1, 1997. The Company prospectively
adopted the requirements of SFAS 125 for the securitization of
consumer loans. The incremental effect of applying the new
requirements was to increase servicing and securitizations income
in 1997 by $32,000 ($19,840, net of tax). Prior to 1997, no gains
were recorded due to the relatively short average life of the con-
sumer loans securitized. Excess servicing fee income was recorded
over the life of each sale transaction.
Off-Balance Sheet Financial Instruments
The nature and composition of the Company’s assets and liabilities
and off-balance sheet items expose the Company to interest rate
risk. The Company’s foreign currency denominated assets and lia-
bilities expose it to foreign currency exchange rate risk. To mitigate
these risks, the Company uses certain types of derivative financial
instruments. The Company enters into interest rate swap agree-
ments (“interest rate swaps”) in the management of its interest rate
exposure. All of the Company’s interest rate swaps are designated
and effective as hedges of specific existing or anticipated assets,