Fifth Third Bank 2004 Annual Report Download - page 51

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp 49
commitments. Additionally, the Bancorp may enter into various
free-standing derivatives (principal only swaps, swaptions, fl oors,
options and interest rate swaps) to economically hedge changes in
fair value of its largely fi xed-rate MSR portfolio.
The Bancorp also enters into foreign exchange contracts and
interest rate swaps, fl oors and caps for the benefi t of customers. The
Bancorp economically hedges signifi cant exposures related to these
free-standing derivatives, entered into for the benefi t of custom-
ers, by entering into offsetting third-party contracts with approved,
reputable counterparties with matching terms and currencies that
are generally settled daily. Credit risks arise from the possible
inability of counterparties to meet the terms of their contracts.
The Bancorp’s exposure is limited to the replacement value of the
contracts rather than the notional, principal or contract amounts.
The Bancorp minimizes the credit risk through credit approvals,
limits and monitoring procedures.
Fair Value Hedges
The Bancorp enters into interest rate swaps to convert its fi xed-rate,
long-term debt to fl oating-rate debt. Decisions to convert fi xed-rate
debt to fl oating are made primarily by consideration of the asset/
liability mix of the Bancorp, the desired asset/liability sensitivity
and interest rate levels. For the years ended December 31, 2004 and
2003, certain interest rate swaps met the criteria required to qualify
for the shortcut method of hedge accounting as defi ned in SFAS
No. 133, as amended. Based on this shortcut method of account-
ing treatment, no ineffectiveness is assumed and fair value changes
in the interest rate swaps are recorded as changes in the value of
both the swap and the long-term debt. If any of the interest rate
swaps do not qualify for the shortcut method of accounting, the
ineffectiveness due to differences in the changes in the fair value of
the interest rate swap and the long-term debt are reported within
interest expense in the Consolidated Statements of Income. For the
years ended December 31, 2004 and 2003, changes in the fair value
of any interest rate swaps attributed to hedge ineffectiveness were
insignifi cant to the Bancorp’s Consolidated Statements of Income.
During 2004 and 2003, the Bancorp terminated interest rate
swaps designated as fair value hedges. In accordance with SFAS No.
133, the fair value of the swaps at the date of termination was recog-
nized as a premium on the previously hedged long-term debt and
is being amortized over the remaining life of the long-term debt as
an adjustment to yield.
The Bancorp also enters into forward contracts to hedge the
forecasted sale of its residential mortgage loans. For the years ended
December 31, 2004 and 2003, the Bancorp met certain criteria to
qualify for matched terms hedge accounting as defi ned in SFAS
No. 133, as amended, on the hedged loans for sale. Based on this
treatment, fair value changes in the forward contracts are recorded
as changes in the value of both the forward contract and loans held
for sale in the Consolidated Balance Sheets.
As of December 31, 2004, there were no instances of desig-
nated hedges no longer qualifying as fair value hedges. The follow-
ing table refl ects all fair value hedges included in the Consolidated
Balance Sheets as of December 31:
($ in millions) 2004 2003
Included in other assets:
Interest rate swaps related to debt . . . . . . . . . $49 54
Included in other liabilities:
Interest rate swaps related to debt . . . . . . . . . 44 —
Forward contracts related to mortgage loans
held for sale . . . . . . . . . . . . . . . . . . . . . . . . 13
Total included in other liabilities . . . . . . . . . . . . $45 3
Cash Flow Hedges
The Bancorp enters into interest rate swaps to convert fl oating-rate
assets and liabilities to fi xed rates and to hedge certain forecasted
transactions. The assets and liabilities are typically grouped and
share the same risk exposure for which they are being hedged. The
Bancorp may also enter into forward contracts to hedge certain
forecasted transactions. As of December 31, 2004 and 2003, $33
million and $8 million, respectively, in net deferred losses, net of
tax, related to cash fl ow hedges were recorded in accumulated other
comprehensive income. Gains and losses on derivative contracts
that are reclassifi ed from accumulated other comprehensive income
to current period earnings are included in the line item in which
the hedged item’s effect in earnings is recorded. As of December
31, 2004, $17 million in deferred losses, net of tax, on derivative
instruments included in accumulated other comprehensive income
are expected to be reclassifi ed into earnings during the next 12
months. All components of each derivative instrument’s gain or loss
are included in the assessment of hedge effectiveness.
The maximum term over which the Bancorp is hedging its
exposure to the variability of future cash fl ows is eight months for
hedges converting fl oating-rate debt to fi xed. During the years
ended December 31, 2004 and 2003, the Bancorp terminated
certain derivatives qualifying as cash fl ow hedges. The fair value
of these contracts, net of tax, is included in accumulated other
comprehensive income and is being amortized over the designated
hedging periods, which range from 17 months to 14 years.
For the year ended December 31, 2004, there were no cash
fl ow hedges that were discontinued related to forecasted transac-
tions deemed not probable of occurring. The Bancorp had less than
$1 million and had $7 million of cash fl ow hedges converting fl oat-
ing-rate debt to fi xed included in other liabilities as of December
31, 2004 and 2003, respectively.
Free-Standing Derivative Instruments
The Bancorp enters into various derivative contracts that focus
on providing derivative products to commercial customers. These
derivative contracts are not designated against specifi c assets or
liabilities on the balance sheet or to forecasted transactions and,
therefore, do not qualify for hedge accounting. These instruments
include foreign exchange derivative contracts entered into for the
benefi t of commercial customers involved in international trade
to hedge their exposure to foreign currency fl uctuations and vari-
ous interest rate derivative contracts for the benefi t of commercial
customers. The Bancorp economically hedges signifi cant exposures
related to these derivative contracts entered into for the benefi t of
customers by generally entering into offsetting third-party forward
contracts with approved reputable counterparties with matching
terms and currencies that are typically settled daily.
Interest rate lock commitments issued on residential mortgage
loan commitments that will be held for resale are also considered
free-standing derivative instruments. The interest rate exposure on
these commitments is economically hedged primarily with forward
contracts. The Bancorp also enters into a combination of freestand-
ing derivative instruments (principal only swaps, swaptions, fl oors,
forward contracts, options and interest rate swaps) to economically
hedge changes in fair value of its largely fi xed rate MSR portfolio.
Additionally, the Bancorp occasionally enters into free-standing
derivative instruments in order to minimize signifi cant fl uctua-
tions in earnings and cash fl ows caused by interest rate volatility.
The interest rate lock commitments and free-standing derivative
instruments related to the MSR portfolio are marked to market and
recorded as a component of mortgage banking net revenue, and
the foreign exchange derivative contracts, other customer deriva-
tive contracts and interest rate risk derivative contracts are marked
to market and recorded within other noninterest income in the
Consolidated Statements of Income. The net gains (losses) recorded
in the Consolidated Statements of Income relating to free-stand-
ing derivative instruments for the years ended December 31 are
summarized in the table that follows on the next page.