Capital One 2006 Annual Report Download - page 126

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The Company has entered into forward exchange contracts to reduce the Companys sensitivity to foreign currency exchange
rate changes on its foreign currency denominated loans. The forward rate agreements allow the Company to lock-in
functional currency equivalent cash flows associated with the foreign currency denominated loans.
During the year ended December 31, 2006, the Company recognized no losses related to the ineffective portions of its cash
flow hedging instruments. During the year ended December 31, 2005, the Company recognized $3.1 million of losses,
recorded in other non-interest income, related to the ineffective portions of its cash flow hedging instruments. The Company
recognized no net gains or losses during the years ended December 31, 2006 and December 31, 2005 for cash flow hedges
that have been discontinued because the forecasted transaction was no longer probable of occurring.
At December 31, 2006, the Company expects to reclassify $0.9 million of net losses, after tax, on derivative instruments from
cumulative other comprehensive income to earnings during the next 12 months as terminated swaps are amortized and as
interest payments and receipts on derivative instruments occur.
Hedge of Net Investment in Foreign Operations
The Company uses forward exchange contracts to protect the value of its investment in its foreign subsidiaries. Realized and
unrealized foreign currency gains and losses from these hedges are not included in the income statement, but are shown in the
translation adjustments in other comprehensive income. The purpose of these hedges is to protect against adverse movements
in exchange rates.
For the years ended December 31, 2006 and 2005, net gains of $1.5 million and $0.3 million respectively, related to these
derivatives were included in the cumulative translation adjustment.
Non-Trading Derivatives
The Company uses interest rate swaps to manage interest rate sensitivity related to loan securitizations. The Company enters
into interest rate swaps with its securitization trust and essentially offsets the derivative with separate interest rate swaps with
third parties.
The Company uses interest rate swaps in conjunction with its auto securitizations. These swaps have zero balance notional
amounts unless the paydown of auto securitizations differs from its scheduled amortization.
The Company enters into customer-oriented derivative financial instruments, including interest rate swaps, options, caps,
floors, and foreign exchange contracts. These customer-oriented positions are matched with offsetting positions to minimize
risk to the Company.
These derivatives do not qualify as hedges and are recorded on the balance sheet at fair value with changes in value included
in current earnings. During the years ended December 31, 2006 and 2005, the Company had net gains of $36.8 million and
$6.6 million, respectively, which are recorded in non-interest income.
In April 2006, the Company entered into derivative instruments to mitigate certain exposures it faced as a result of the
expected acquisition of North Fork. The position was designed to protect the Companys tangible capital ratios from falling
below a desired level in the event that subsequent increases in interest rates had reduced the mark-to-market value of North
Forks balance sheet prior to closing. The Companys maximum negative exposure was no more than approximately $50
million. The derivative instruments were not treated as designated hedges and were marked to market through the income
statement until expiration. During their existence, $30.2 million was recognized as a reduction to mortgage banking
operations income as a mark to market adjustment. The derivative instruments expired out of the money and unexercised on
October 2, 2006 with a $19.9 million reduction to mortgage banking operations income.
Mortgage Banking Derivatives
The Company, as part of its mortgage banking operations, enters into commitments to originate or purchase loans whereby
the interest rate of the loan is determined prior to funding (interest rate lock commitment). Interest rate lock commitments
on mortgage loans that the Company intends to sell in the secondary market are considered freestanding derivatives. These
derivatives are carried at fair value with changes in fair value reported as a component of gain on sale of loans. In accordance
with Staff Accounting Bulletin No, 105, Application of Accounting Principles to Loan Commitments, interest rate lock
commitments are initially valued at zero. Changes in fair value subsequent to inception are determined based on current
secondary market prices for underlying loans with similar coupons, maturity and credit quality, subject to the anticipated
probability that the loans will fund within the terms of the commitment. The initial value inherent in the loan commitments at
origination is recognized through gain on sale of loans when the underlying loan is sold. Both the interest rate lock