DERIVATIVES

General

The Company uses derivative financial instruments primarily to help manage exposure to interest rate, foreign exchange, equity and credit risk, as well as to reduce the effects that changes in interest rates may have on net income, the fair value of assets and liabilities, and cash flows. The Company also enters into derivatives with customers to facilitate their risk management activities. The Company uses derivative financial instruments as risk management tools and not for speculative trading purposes. The fair value of all derivative balances is recorded within Other assets and Other liabilities on the Condensed Consolidated Balance Sheet.

See Note 16 for discussion of the valuation methodology for derivative instruments.

Derivatives represent contracts between parties that usually require little or no initial net investment and result in one party delivering cash or another type of asset to the other party based on a notional amount and an underlying as specified in the contract. Derivative transactions are often measured in terms of notional amount, but this amount is generally not exchanged and is not recorded on the balance sheet. The notional amount is the basis to which the underlying is applied to determine required payments under the derivative contract. The underlying is a referenced interest rate (commonly Overnight Indexed Swap ("OIS") or LIBOR), security price, credit spread or other index. Derivative balances are presented on a gross basis taking into consideration the effects of legally enforceable master netting agreements.

In the third quarter of 2013, in accordance with ASU 2013-10, the Company adopted the OIS rate, which is used for determining the fair value of certain hedge and derivative contracts, including all collateralized interest rate swaps, caps, and floors. The OIS rate will continue to be used for new derivative contracts in these portfolios. The impact of this change was not material to the Company's financial position or results of operations.

Through the Company’s capital markets and mortgage banking activities, it is subject to price risk. The Company employs various tools to measure and manage price risk in its portfolios. In addition, the Board of Directors has established certain limits relative to positions and activities. The level of price risk exposure at any given time depends on the market environment and expectations of future price and market movements and will vary from period to period.

To qualify for hedge accounting, the Company is required to designate SCUSA’s derivatives as accounting hedges on or after the Change in Control date. The Company has designated certain of SCUSA’s derivatives as accounting hedges beginning April 1, 2014.

Credit Risk Contingent Features

The Company has entered into certain derivative contracts that require the posting of collateral to counterparties when these contracts are in a net liability position. The amount of collateral to be posted is based on the amount of the net liability and thresholds generally related to the Company's long-term senior unsecured credit ratings. In a limited number of instances, counterparties also have the right to terminate their International Swaps and Derivatives Association, Inc. ("ISDA") master agreements if the Company's ratings fall below investment grade. As of June 30, 2014, derivatives in this category had a fair value of $27.2 million. The credit ratings of the Bank and SHUSA are currently considered investment grade. The Bank estimates a further 1- or 2- notch downgrade by either S&P or Moody's would require the Bank to post up to an additional $4.3 million or $4.5 million, respectively, to comply with existing derivative agreements.

As of June 30, 2014 and December 31, 2013, the aggregate fair value of all derivative contracts with credit risk contingent features (i.e., those containing collateral posting or termination provisions based on our ratings) that were in a net liability position totaled $164.8 million and $198.8 million, respectively. The Company had $165.9 million and $203.9 million in cash and securities collateral posted to cover those positions as of June 30, 2014 and December 31, 2013, respectively.

NOTE 10. DERIVATIVES (continued)

Fair Value Hedges

The Company enters into cross-currency swaps to hedge its foreign currency exchange risk on certain Euro-denominated investments. The Company also entered into interest rate swaps to hedge the interest rate risk on certain fixed rate investments. These derivatives are designated as fair value hedges at inception. The Company includes all components of each derivative's gain or loss in the assessment of hedge effectiveness. The earnings impact of the ineffective portion of these hedges was not material for the three-month and six-month periods ended June 30, 2014 or June 30, 2013. The last of the hedges is scheduled to expire in July 2019.

The Company has historically entered into pay-variable, receive-fixed interest rate swaps to hedge changes in fair values of certain debt obligations. At June 30, 2014, the Company had $11.7 million of deferred net after-tax losses on terminated derivative instruments that were hedging fair value changes. These losses will continue to be deferred in Borrowings and will be reclassified into interest expense over the remaining lives of the hedged assets and liabilities. During the three-month and six-month periods ended June 30, 2014, $0.7 million and $1.3 million of the losses were recognized in the Condensed Consolidated Statements of Operations.

Cash Flow Hedges

Management uses derivative instruments, which are designated as hedges, to mitigate the impact of interest rate movements on the fair value of certain liabilities, assets and on highly probable forecasted cash flows. These instruments primarily include interest rate swaps that have underlying interest rates based on key benchmark indices and forward sale or purchase commitments. The nature and volume of the derivative instruments used to manage interest rate risk depend on the level and type of assets and liabilities on the balance sheet and the risk management strategies for the current and anticipated interest rate environment.

Interest rate swaps are generally used to convert fixed-rate assets and liabilities to variable rate assets and liabilities and vice versa. The Company utilizes interest rate swaps that have a high degree of correlation to the related financial instrument.

The last of the hedges is scheduled to expire in December 2030. The Company includes all components of each derivative's gain or loss in the assessment of hedge effectiveness. The earnings impact of the ineffective portion of these hedges was not material for the three-month and six-month periods ended June 30, 2014 or June 30, 2013. As of June 30, 2014, the Company expects approximately $8.5 million of gross losses recorded in accumulated other comprehensive income to be reclassified to earnings during the subsequent twelve months as the future cash flows occur.

NOTE 10. DERIVATIVES (continued)

Derivatives Designated in Hedge Relationships – Notional and Fair Values

Derivatives designated as accounting hedges at June 30, 2014 and December 31, 2013 included:



	Notional Amount		Asset		Liability		Weighted Average Receive Rate		Weighted Average Pay Rate		Weighted Average Life (Years)
	(dollars in thousands)
June 30, 2014
Fair value hedges:
Cross-currency swaps	$	20,540	$	843	$	1,538	4.76	%	4.75	%	1.61
Interest rate swaps	190,000		12		765		0.89	%	2.36	%	4.68
Cash flow hedges:
Pay fixed — receive floating interest rate swaps	9,024,501		2,102		44,281		0.10	%	0.49	%	2.27
Total	$	9,235,041	$	2,957	$	46,584	0.13	%	0.54	%	2.32

December 31, 2013
Fair Value hedges:
Cross-currency swaps	$	19,995	$	1,073	$	1,924	4.76	%	4.75	%	2.11
Cash flow hedges:
Pay fixed — receive floating interest rate swaps	2,700,312		4,803		58,381		0.24	%	2.46	%	1.89
Total	$	2,720,307	$	5,876	$	60,305	0.27	%	2.47	%	1.90

See Note 13 for detail of the amounts included in accumulated other comprehensive income related to derivatives activity.

Other Derivative Activities

The Company also enters into derivatives that are not designated as accounting hedges under GAAP. The majority of these derivatives are customer-related derivatives relating to foreign exchange and lending arrangements. In addition, derivatives are used to manage risks related to residential and commercial mortgage banking and investing activities. Although these derivatives are used to hedge risk and are considered economic hedges, they are not designated as accounting hedges because the contracts they are hedging are typically also carried at fair value on the balance sheet, resulting in generally symmetrical accounting treatment for both the hedging instrument and the hedged item.

Mortgage Banking Derivatives

The Company's derivative portfolio includes mortgage banking interest rate lock commitments, forward sale commitments and interest rate swaps. As part of its overall business strategy, the Bank originates fixed-rate residential mortgages. It sells a portion of this production to FHLMC, FNMA, and private investors. The Company uses forward sales as a means of hedging against the economic impact of changes in interest rates on the mortgages that are originated for sale and on interest rate lock commitments.

The Company typically retains the servicing rights related to residential mortgage loans that are sold. Residential MSRs are accounted for at fair value. As deemed appropriate, the Company economically hedges MSRs using interest rate swaps and forward contracts to purchase mortgage-backed securities.

NOTE 10. DERIVATIVES (continued)

Customer-related derivatives

The Company offers derivatives to its customers in connection with their risk management needs. These financial derivative transactions primarily consist of interest rate swaps, caps, floors and foreign exchange contracts. Risk exposure from customer positions is managed through transactions with other dealers, including Santander.

Other derivative activities

The Company uses foreign exchange contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities. Foreign exchange contracts, which include spot and forward contracts as well as cross currency swaps, represent agreements to exchange the currency of one country for the currency of another country at an agreed-upon price on an agreed-upon settlement date. Exposure to gains and losses on these contracts will increase or decrease over their respective lives as currency exchange and interest rates fluctuate.

In March 2014, SCUSA entered into a financing arrangement with a third party under which SCUSA pledged certain bonds retained in its own securitizations in exchange for approximately $251 million in cash. In conjunction with this financing arrangement, SCUSA entered into a total return swap related to the bonds as an effective avenue to monetize SCUSA’s retained bonds as a source of financing. SCUSA will receive at fixed return on the bonds in exchange for paying a variable rate of three-month LIBOR plus 75 basis points. In addition, at maturity, SCUSA will receive a payment from, or make a payment to, the counterparty based on the change in fair value of the bonds during the facility's one-year term. Throughout the facility's term, the party in a net liability position must post collateral. SCUSA has the ability to substitute collateral and may do so if a bond is set to begin amortizing. Alternatively, the amortization may be utilized to reduce the notional amount of the facility.

Other derivative instruments primarily include forward contracts related to certain investment securities sales, an overnight indexed swap, a total return swap on Visa, Inc. Class B common shares, and equity options, which manage our market risk associated with certain investments and customer deposit products.

NOTE 10. DERIVATIVES (continued)

Derivatives Not Designated in Hedge Relationships – Notional and Fair Values

Other derivative activities at June 30, 2014 and December 31, 2013 included:



	Notional				Asset derivatives Fair value				Liability derivatives Fair value
	June 30, 2014		December 31, 2013⁽¹⁾		June 30, 2014		December 31, 2013⁽¹⁾		June 30, 2014		December 31, 2013⁽¹⁾
	(in thousands)
Mortgage banking derivatives:
Forward commitments to sell loans	$	332,869	$	169,608	$	—	$	2,101	$	3,151	$	—
Interest rate lock commitments	218,784		75,787		4,092		547		—		—
Mortgage servicing rights	245,000		245,000		722		6,155		188		488
Total mortgage banking risk management	796,653		490,395		4,814		8,803		3,339		488

Customer related derivatives:
Swaps receive fixed	6,688,484		5,665,350		191,759		166,871		7,666		28,561
Swaps pay fixed	6,673,094		5,661,555		20,334		54,693		174,726		166,473
Other	1,292,987		1,385,904		2,825		4,247		2,232		3,635
Total customer related derivatives	14,654,565		12,712,809		214,918		225,811		184,624		198,669

Other derivative activities:
Foreign exchange contracts	1,193,297		1,253,395		7,593		11,631		6,199		9,745
Interest rate swap agreements	3,168,861		—		—		—		24,240		—
Interest rate cap agreements	6,398,207		—		46,631		—		—		—
Options for interest rate cap agreements	6,398,207		—		—		—		46,677		—
Other	642,727		291,437		5,912		4,764		7,088		4,496

Total	$	33,252,517	$	14,748,036	$	279,868	$	251,009	$	272,167	$	213,398

(1) Balances at December 31, 2013 do not include SCUSA.

NOTE 10. DERIVATIVES (continued)

The Company is the holder of a warrant that gives it the right, if certain vesting conditions are satisfied, to purchase additional shares in a company in which it has a cost method investment. This warrant was issued in 2012 and is carried at its estimated fair value of zero at June 30, 2014 and December 31, 2013.

Gains (Losses) on All Derivatives

The following Condensed Consolidated Statement of Operations line items were impacted by the Company’s derivative activities for the three-month and six-month periods ended June 30, 2014 and 2013, respectively:



		Three-Month Period Ended June 30,				Six-Month Period Ended June 30,
Derivative Activity	Accounts	2014		2013		2014		2013
		(in thousands)
Fair value hedges:
Cross-currency swaps	Miscellaneous income	1,454		(7	)	773		1,739
Interest rate swaps	Miscellaneous income	(1,488	)	—		(753	)	—
Cash flow hedges:
Pay fixed-receive variable interest rate swaps	Net interest income	(13,782	)	(17,578	)	(27,467	)	(35,311	)
Other derivative activities:
Forward commitments to sell loans	Mortgage banking income	(3,243	)	40,616		(5,252	)	40,360
Interest rate lock commitments	Mortgage banking income	2,364		(21,148	)	3,545		(24,868	)
Mortgage servicing rights	Mortgage banking income	2,629		51		(5,132	)	870
Customer related derivatives	Miscellaneous income	3,548		7,155		3,661		9,544
Foreign exchange	Miscellaneous income	419		(632	)	(492	)	(1,702	)
SCUSA derivatives	Miscellaneous income	5,114		—		18,139		—
SCUSA derivatives	Net interest income	(2,141	)	—		(3,980	)	—
Other	Miscellaneous income	(661	)	—		(1,309	)	—
	Net interest income	—		(2,418	)	—		(3,121	)
	Non-interest income	—		(15,508	)	—		(15,508	)

Disclosures about Offsetting Assets and Liabilities

The Company enters into legally enforceable master netting agreements, which reduce risk by permitting netting of transactions with the same counterparty on the occurrence of certain events. A master netting agreement allows two counterparties the ability to net-settle amounts under all contracts, including any related collateral posted, through a single payment and in a single currency. The right to offset and certain terms regarding the collateral process, such as valuation, credit events and settlement, are contained in the ISDA master agreement. The Company's financial instruments, including resell and repurchase agreements, securities lending arrangements, derivatives and cash collateral, may be eligible for offset on its Condensed Consolidated Balance Sheet.

NOTE 10. DERIVATIVES (continued)

Information about financial assets and liabilities that are eligible for offset on the Condensed Consolidated Balance Sheet as of June 30, 2014 and December 31, 2013, respectively, is presented in the following tables:



	Offsetting of Financial Assets
							Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet
	Gross Amounts of Recognized Assets		Gross Amounts Offset in the Condensed Consolidated Balance Sheet		Net Amounts of Assets Presented in the Condensed Consolidated Balance Sheet		Financial Instruments		Cash Collateral Received		Net Amount
	(in thousands)
June 30, 2014
Fair value hedges	$	855	$	—	$	855	$	—	$	—	$	855
Cash flow hedges	2,102		—		2,102		—		—		2,102
Other derivative activities⁽¹⁾	275,776		31,084		244,692		10,040		2,420		232,232
Total derivatives subject to a master netting arrangement or similar arrangement	278,733		31,084		247,649		10,040		2,420		235,189
Total derivatives not subject to a master netting arrangement or similar arrangement⁽²⁾	4,092		—		4,092		—		—		4,092
Total Derivatives Assets	$	282,825	$	31,084	$	251,741	$	10,040	$	2,420	$	239,281

Total Financial Assets	$	282,825	$	31,084	$	251,741	$	10,040	$	2,420	$	239,281

December 31, 2013
Fair value hedges	$	1,073	$	—	$	1,073	$	—	$	—	$	1,073
Cash flow hedges	4,803		—		4,803		—		—		4,803
Other derivative activities⁽¹⁾	249,619		34,394		215,225		3,992		47,706		163,527
Total derivatives subject to a master netting arrangement or similar arrangement	255,495		34,394		221,101		3,992		47,706		169,403
Total derivatives not subject to a master netting arrangement or similar arrangement⁽²⁾	1,390		—		1,390		—		—		1,390
Total Derivatives Assets	$	256,885	$	34,394	$	222,491	$	3,992	$	47,706	$	170,793

Total Financial Assets	$	256,885	$	34,394	$	222,491	$	3,992	$	47,706	$	170,793


(1)	Includes customer-related and other derivatives


(2)	Includes mortgage banking derivatives

NOTE 10. DERIVATIVES (continued)



	Offsetting of Financial Liabilities
							Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet
	Gross Amounts of Recognized Liabilities		Gross Amounts Offset in the Condensed Consolidated Balance Sheet		Net Amounts of Liabilities Presented in the Condensed Consolidated Balance Sheet		Financial Instruments		Cash Collateral Pledged		Net Amount
	(in thousands)
June 30, 2014
Fair value hedges	$	2,303	$	—	$	2,303	$	—	$	703	$	1,600
Cash flow hedges	68,521		—		68,521		25,246		36,945		6,330
Other derivative activities⁽¹⁾	247,788		31,084		216,704		58,018		143,688		14,998
Total derivatives subject to a master netting arrangement or similar arrangement	318,612		31,084		287,528		83,264		181,336		22,928
Total derivatives not subject to a master netting arrangement or similar arrangement⁽²⁾	139		—		139		—		—		139
Total Derivatives Liabilities	$	318,751	$	31,084	$	287,667	$	83,264	$	181,336	$	23,067

Total Financial Liabilities	$	318,751	$	31,084	$	287,667	$	83,264	$	181,336	$	23,067

December 31, 2013
Fair value hedges	$	1,924	$	—	$	1,924	$	—	$	1,311	$	613
Cash flow hedges	58,381		—		58,381		34,881		40,817		(17,317		)
Other derivative activities⁽¹⁾	213,400		34,394		179,006		102,402		37,538		39,066
Total derivatives subject to a master netting arrangement or similar arrangement	273,705		34,394		239,311		137,283		79,666		22,362
Total derivatives not subject to a master netting arrangement or similar arrangement⁽²⁾	—		—		—		—		—		—
Total Derivatives Liabilities	$	273,705	$	34,394	$	239,311	$	137,283	$	79,666	$	22,362

Total Financial Liabilities	$	273,705	$	34,394	$	239,311	$	137,283	$	79,666	$	22,362


(1)	Includes customer-related and other derivatives


(2)	Includes mortgage banking derivatives