Fifth Third Bank 2007 Annual Report Download - page 70

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp
68
Cash Flow Hedges
The Bancorp may enter into interest rate swaps to convert
floating-rate assets and liabilities to fixed rates or to hedge certain
forecasted transactions. The assets or liabilities are typically
grouped and share the same risk exposure for which they are
being hedged. The Bancorp may also enter into interest rate caps
and floors to limit cash flow variability of floating rate assets and
liabilities. As of December 31, 2007, all hedges designated as cash
flow hedges are assessed for effectiveness using regression
analysis. Ineffectiveness is generally measured as the amount by
which the cumulative change in the fair value of the hedging
instrument exceeds the present value of the cumulative change in
the hedged item’s expected cash flows. Ineffectiveness is reported
within other noninterest income in the Consolidated Statements
of Income. For the year ended December 31, 2007, the Bancorp
recognized a net gain of less than $1 million attributable to cash
flow hedge ineffectiveness. During the fourth quarter of 2007,
the Bancorp terminated certain interest rate swaps designated as
cash flow hedges. In conjunction with this termination, the
Bancorp reclassified $22 million of losses into earnings as it was
determined that the original forecasted transaction was no longer
probable of occurring by the end of the originally specified time
period or within the additional period of time as defined in SFAS
No. 133. These losses were reported within other noninterest
income in the Consolidated Statements of Income.
As of December 31, 2007, $25 million of deferred gains on
cash flow derivatives are recorded in accumulated other
comprehensive income. Gains and losses on derivative contracts
are reclassified from accumulated other comprehensive income to
current period earnings when the forecasted transaction affects
earnings and are included in the line item in which the hedged
item's effect in earnings is recorded. As of December 31, 2007, $3
million in net deferred gains, net of tax, recorded in accumulated
other comprehensive income are expected to be reclassified into
earnings during the next twelve months.
In prior periods, the Bancorp terminated certain derivatives
qualifying as cash flow hedges. The deferred gains or losses of
those terminated instruments, net of tax, were included in
accumulated other comprehensive income and amortized over the
designated hedging periods. As of December 31, 2006, less than
$1 million of deferred losses, net of tax, related to terminated cash
flow hedges were recorded in accumulated other comprehensive
income.
The following table reflects the notional amount and market
value of all cash flow hedges included in the Consolidated Balance
Sheets as of December 31:
2007 2006
($ in millions)
Notional
Amount Fair Value
Notional
Amount Fair Value
Included in other assets:
Interest rate floors related to commercial loans $1,500 $ 107 - -
Interest rate caps related to debt 1,750 11 --
Total included in other assets $118 -
Included in other liabilities:
Interest rate swaps related to consumer loans $1,000 $11 --
Total included in other liabilities $11 -
Free-Standing Derivative Instruments
The majority of the free-standing derivative instruments the
Bancorp enters into are for the benefit of commercial customers.
These derivative contracts are not designated against specific
assets or liabilities on the Consolidated Balance Sheets or to
forecasted transactions and, therefore, do not qualify for hedge
accounting. These instruments include foreign exchange
derivative contracts entered into for the benefit of commercial
customers involved in international trade to hedge their exposure
to foreign currency fluctuations, commodity contracts to hedge
such items as natural gas and various other derivative contracts.
The Bancorp may economically hedge significant exposures
related to these derivative contracts entered into for the benefit of
customers by entering into offsetting contracts with approved,
reputable, independent counterparties with substantially matching
terms. The Bancorp hedges its interest rate exposure on
commercial customer transactions by executing offsetting swap
agreements with primary dealers. Revaluation gains and losses on
foreign exchange, commodity and other commercial customer
derivative contracts are recorded as a component of corporate
banking revenue in the Consolidated Statements of Income.
In 2007, the Bancorp began offering its customers an equity-
linked certificate of deposit that has a return linked to equity
indices. Under SFAS No. 133, a certificate of deposit that pays
interest based on changes on an equity index is a hybrid
instrument that requires separation into a host contract (the
certificate of deposit) and an embedded derivative contract
(written equity call option). The Bancorp enters into an offsetting
derivative contract to economically hedge the exposure taken
through the issuance of equity-linked certificates of deposit. Both
the embedded derivative and derivative contract entered into by
the Bancorp are recorded as free-standing derivatives and
recorded at fair value with offsetting gains and losses recognized
in the Consolidated Statements of Income.
The Bancorp enters into foreign exchange derivative
contracts to economically hedge certain foreign denominated
loans. Derivative instruments that the Bancorp may use to
economically hedge these foreign denominated loans include
foreign exchange swaps and forward contracts. The Bancorp
does not designate these instruments against the foreign
denominated loans, and therefore, does not obtain hedge
accounting treatment. Revaluation gains and losses on such
foreign currency derivative contracts are recorded within other
noninterest income in the Consolidated Statements of Income, as
are revaluation gains and losses on foreign denominated loans.
As part of its overall risk management strategy relative to its
mortgage banking activity, the Bancorp may enter into various
free-standing derivatives (principal-only swaps, swaptions, floors,
options and interest rate swaps) to economically hedge changes in
fair value of its largely fixed-rate MSR portfolio. Principal-only
swaps hedge the mortgage-LIBOR spread because these swaps
appreciate in value as a result of tightening spreads. Principal-only
swaps also provide prepayment protection by increasing in value
when prepayment speeds increase, as opposed to MSRs that lose
value in a faster prepayment environment. Receive fixed/pay
floating interest rate swaps and swaptions increase in value when
interest rates do not increase as quickly as expected. The Bancorp
enters into forward contracts to economically hedge the change in
fair value of certain residential mortgage loans held for sale due to
changes in interest rates. The Bancorp enters into forward swaps
to economically hedge the change in fair value of certain
commercial mortgage loans held for sale due to changes in interest
rates. Interest rate lock commitments issued on commercial and
residential mortgage loan commitments that will be held for resale
are also considered free-standing derivative instruments and the
interest rate exposure on these commitments is economically
hedged primarily with forward contracts. Revaluation gains and
losses from free-standing derivatives related to mortgage banking