DERIVATIVES

In the normal course of business, the Company enters into a variety of derivative transactions in order to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates and foreign currency exchange rates. The Company does not use derivatives for speculative purposes.

The Company’s derivative instruments are recognized on the Consolidated Balance Sheets at fair value. Information regarding the valuation methodology and inputs used to estimate the fair value of the Company’s derivative instruments is described in Note 12 “Fair Value Measurements.”

At September 30, 2017, the overall derivative asset value decreased $31 million and the liability balance decreased by $417 million from December 31, 2016. These decreases were primarily due to a change in the presentation of variation margin payments in the Consolidated Balance Sheet in 2017. Effective January 3, 2017, variation margin payments made on certain centrally cleared derivative contracts are legally classified as settlement of those derivatives (rather than the posting of collateral). As a result of this change, the Company modified its balance sheet presentation of certain interest rate swaps in 2017, such that the fair value of the swaps and the associated variation margin balances are reported as a single unit of account in derivative assets and/or derivative liabilities. At December 31, 2016, these variation margin balances were characterized as collateral. Variation margin balances legally characterized as collateral are reported in interest-bearing cash and due from banks on the Consolidated Balance Sheets.

The following table presents derivative instruments included on the Consolidated Balance Sheets in derivative assets and derivative liabilities:



	September 30, 2017								December 31, 2016
(in millions)	Notional Amount⁽¹⁾		Derivative Assets⁽²⁾			Derivative Liabilities⁽²⁾			Notional Amount⁽¹⁾		Derivative Assets			Derivative Liabilities
Derivatives designated as hedging instruments:
Interest rate contracts		$17,300		$6			$—			$13,350		$52			$193
Derivatives not designated as hedging instruments:
Interest rate contracts	69,436		502			338			54,656		557			452
Foreign exchange contracts	10,147		146			142			8,039		134			126
Other contracts	1,256		10			5			1,498		16			7
Total derivatives not designated as hedging instruments			658			485					707			585
Gross derivative fair values			664			485					759			778
Less: Gross amounts offset in the Consolidated Balance Sheets ⁽³⁾			(65		)	(65		)			(106		)	(106		)
Less: Cash collateral applied ⁽³⁾			(3		)	(178		)			(26		)	(13		)
Total net derivative fair values presented in the Consolidated Balance Sheets				$596			$242					$627			$659

⁽¹⁾The notional or contractual amount of interest rate derivatives and foreign exchange contracts is the amount upon which interest and other payments under the contract are based. For interest rate contracts, the notional amount is typically not exchanged. Therefore, notional amounts should not be taken as the measure of credit or market risk, as they do not measure the true economic risk of these contracts.

⁽²⁾ Amounts reflect changes in the treatment of variation margin on certain centrally cleared derivatives.

⁽³⁾Amounts represent the impact of legally enforceable master netting agreements that allow the Company to settle positive and negative positions.

The Company’s derivative transactions are internally divided into three sub-groups: institutional, customer and residential loan.

Institutional derivatives

The institutional derivatives portfolio primarily consists of interest rate swap agreements that are used to hedge the interest rate risk associated with the Company’s loans and financing liabilities (i.e., borrowed funds, deposits, etc.). The goal of the Company’s interest rate hedging activity is to manage interest rate sensitivity so that movements in interest rates do not significantly adversely affect net interest income.

The Company enters into certain interest rate swap agreements to hedge the risk associated with floating rate loans. By entering into pay-floating/receive-fixed interest rate swaps, the Company is able to minimize the variability in the cash flows of these assets due to changes in interest rates. The Company has outstanding interest rate swap agreements designed to hedge a portion of the Company’s borrowed funds and deposit liabilities. By entering into a pay-fixed/receive-floating interest rate swap, a portion of these liabilities has been effectively converted to a fixed-rate liability for the term of the interest rate swap agreement.

The Company also uses receive-fixed/pay-floating interest rate swaps to manage the interest rate exposure on its medium-term borrowings.

Customer derivatives

The customer derivatives portfolio consists of interest rate swap agreements and option contracts that are transacted to meet the financing needs of the Company’s customers. Swap agreements and interest rate option agreements are transacted to effectively minimize the Company’s market risk associated with the customer derivative products. The customer derivatives portfolio also includes foreign exchange contracts that are entered into on behalf of customers for the purpose of hedging exposure related to cash orders and loans and deposits denominated in foreign currencies. The primary risks associated with these transactions arise from exposure to changes in foreign currency exchange rates and the ability of the counterparties to meet the terms of the contract. To manage this market risk, the Company enters into offsetting foreign exchange contracts.

Residential loan derivatives

The Company enters into residential loan commitments that allow residential mortgage customers to lock in the interest rate on a residential mortgage while the loan undergoes the underwriting process. The Company also uses forward sales contracts to protect the value of residential mortgage loans and loan commitments that are being underwritten for future sale to investors in the secondary market.

Derivatives designated as hedging instruments

The Company’s institutional derivatives portfolio qualifies for hedge accounting treatment. This includes interest rate swaps that are designated in highly effective fair value and cash flow hedging relationships. The Company formally documents at inception all hedging relationships, as well as risk management objectives and strategies for undertaking various accounting hedges. Additionally, the Company uses dollar offset or regression analysis at the hedge’s inception, and monthly thereafter, to assess whether the derivatives are expected to be, or have been, highly effective in offsetting changes in the hedged item’s expected cash flows. The Company discontinues hedge accounting treatment when it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge and then reflects changes in fair value in earnings after termination of the hedge relationship.

The Company has certain derivative transactions which are designated as fair value or cash flow hedges, described as follows:

Fair value hedges

The Company has entered into interest rate swap agreements to manage the interest rate exposure on its medium-term borrowings. The change in value of fair value hedges, to the extent that the hedging relationship is effective, is recorded through earnings and offset against the change in the fair value of the hedged item.

The following table presents the effect of fair value hedges on other income:



	Amounts Recognized in Other Income for the
	Three Months Ended September 30, 2017								Three Months Ended September 30, 2016
(in millions)	Derivative			Hedged Item		Hedge Ineffectiveness			Derivative			Hedged Item		Hedge Ineffectiveness
Hedges of interest rate risk on borrowings using interest rate swaps		($5	)		$4		($1	)		($27	)		$25		($2	)



	Amounts Recognized in Other Income for the
	Nine Months Ended September 30, 2017							Nine Months Ended September 30, 2016
(in millions)	Derivative		Hedged Item			Hedge Ineffectiveness		Derivative		Hedged Item			Hedge Ineffectiveness
Hedges of interest rate risk on borrowings using interest rate swaps		$5		($5	)		$—		$57		($58	)		($1	)

Cash flow hedges

The Company has outstanding interest rate swap agreements designed to hedge a portion of the Company’s floating rate assets, and financing liabilities (including its borrowed funds). All of these swaps have been deemed as highly effective cash flow hedges. The effective portion of the hedging gains and losses associated with these hedges are recorded in OCI; the ineffective portion of the hedging gains and losses is recorded in earnings (other income). Hedging gains and losses on derivative contracts reclassified from OCI to current period earnings are included in the line item in the accompanying Consolidated Statements of Operations in which the hedged item is recorded and in the same period that the hedged item affects earnings. During the next 12 months, there are $7 million in pre-tax net losses on derivative instruments included in OCI expected to be reclassified to net interest income in the Consolidated Statements of Operations.

Hedging gains and losses associated with the Company’s cash flow hedges are immediately reclassified from OCI to current period earnings (other income) if it becomes probable that the hedged forecasted transactions will not occur during the originally specified time period.

The following table presents the effect of cash flow hedges on net income and stockholders' equity:



	Amounts Recognized for the
	Three Months Ended September 30,						Nine Months Ended September 30,
(in millions)	2017			2016			2017			2016
Effective portion of (loss) gain recognized in OCI ⁽¹⁾		($2	)		($1	)		$35			$74
Amounts reclassified from OCI to interest income ⁽²⁾	3			23			23			66
Amounts reclassified from OCI to interest expense ⁽²⁾	1			(8		)	(2		)	(24		)
Amounts reclassified from OCI to other income ⁽³⁾	—			(5		)	—			(5		)

⁽¹⁾The cumulative effective gains and losses on the Company’s cash flow hedging activities are included on the accumulated other comprehensive loss line item on the Consolidated Balance Sheets.

⁽²⁾This amount includes both (a) the amortization of effective gains and losses associated with the Company’s terminated cash flow hedges and (b) the current reporting period’s interest settlements realized on the Company’s active cash flow hedges. Both (a) and (b) were previously included on the accumulated other comprehensive loss line item on the Consolidated Balance Sheets and were subsequently recorded as adjustments to the interest income or expense of the underlying hedged item.

⁽³⁾This includes gains and losses attributable to previously hedged cash flows where the likelihood of occurrence of those cash flows is no longer probable.

Derivatives not designated as hedging instruments

Economic hedges

The Company’s customer derivatives are recorded on the Consolidated Balance Sheets at fair value. These include interest rate and foreign exchange derivative contracts that are designed to meet the hedging and financing needs of the Company’s customers. Mark-to-market adjustments to the fair value of these contracts are included in foreign exchange and interest rate products on the Consolidated Statement of Operations. The mark-to-market gains and losses associated with the customer derivatives are mitigated by the mark-to-market gains and losses on the offsetting interest rate and foreign exchange derivative contracts transacted.

The Company’s residential loan derivatives (including residential loan commitments and forward sales contracts) are recorded on the Consolidated Balance Sheets at fair value. Mark-to-market adjustments to the fair value of residential loan commitments and forward sale contracts are included in noninterest income under mortgage banking fees.

The following table presents the effect of customer derivatives and economic hedges on noninterest income:



	Amounts Recognized in Noninterest Income for the
	Three Months Ended September 30,						Nine Months Ended September 30,
(in millions)	2017			2016			2017			2016
Customer derivative contracts
Customer interest rate contracts ⁽¹⁾		$12			($32	)		$92			$63
Customer foreign exchange contracts ⁽¹⁾	61			17			157			45
Residential loan commitments ⁽²⁾	—			1			3			8
Economic hedges
Offsetting derivatives transactions to hedge interest rate risk on customer interest rate contracts ⁽¹⁾	(2		)	45			(58		)	(31		)
Offsetting derivatives transactions to hedge foreign exchange risk on customer foreign exchange contracts ⁽¹⁾	(55		)	(19		)	(140		)	(46		)
Forward sale contracts ⁽²⁾	(1		)	4			(7		)	(6		)
Total		$15			$16			$47			$33

⁽¹⁾Reported in foreign exchange and interest rate products on the Consolidated Statements of Operations.

⁽²⁾Reported in mortgage banking fees on the Consolidated Statements of Operations.