NOTE 9—DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

Use of Derivatives

We manage our asset and liability position and market risk exposure in accordance with prescribed risk management policies and limits established by our Market and Liquidity Risk Policy which is approved by our Board of Directors. Our primary market risk stems from the impact on our earnings and economic value of equity from changes in interest rates and, to a lesser extent, changes in foreign exchange rates. We employ several techniques to manage our interest rate sensitivity, which include changing the duration and re-pricing characteristics of various assets and liabilities by using interest rate derivatives. Our current asset and liability management policy also includes the use of derivatives to hedge foreign currency denominated transactions to limit our earnings and capital ratio exposure to foreign exchange risk. We execute our derivative contracts in both the over-the-counter (“OTC”) and exchange-traded derivative markets. The majority of our derivatives are interest rate swaps. In addition, we may use a variety of other derivative instruments, including caps, floors, options, futures and forward contracts, to manage our interest rate and foreign exchange risk. We also offer various derivatives to our customers as part of our Commercial Banking business but usually offset our exposure through derivative transactions with other counterparties.

Accounting for Derivatives

Our derivatives are designated as either qualifying accounting hedges or free-standing derivatives. Free-standing derivatives consist of customer-accommodation derivatives and economic hedges that do not qualify for hedge accounting. Qualifying accounting hedges are designated as fair value hedges, cash flow hedges or net investment hedges.

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Fair Value Hedges: We designate derivatives as fair value hedges to manage our exposure to changes in the fair value of certain financial assets and liabilities, which fluctuate in value as a result of movements in interest rates. Changes in the fair value of derivatives designated as fair value hedges are recorded in earnings together with offsetting changes in the fair value of the hedged item and any resulting ineffectiveness. Our fair value hedges consist of interest rate swaps that are intended to modify our exposure to interest rate risk on various fixed-rate assets and liabilities.

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Cash Flow Hedges: We designate derivatives as cash flow hedges to manage our exposure to variability in cash flows related to forecasted transactions. Changes in the fair value of derivatives designated as cash flow hedges are recorded as a component of AOCI, to the extent that the hedge relationships are effective, and amounts are reclassified from AOCI to earnings as the forecasted transactions occur. To the extent that any ineffectiveness exists in the hedge relationships, the amounts are recorded in current period earnings. Our cash flow hedges consist of interest rate swaps that are intended to hedge the variability in interest payments on some of our variable-rate assets through 2019. These hedges have the effect of converting some of our variable-rate assets to a fixed rate. We also have entered into forward foreign currency derivative contracts to hedge our exposure to variability in cash flows related to foreign currency denominated intercompany borrowings.

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Net Investment Hedges: We use net investment hedges to manage the foreign currency exposure related to our non-dollar net investments in foreign operations that have functional currencies other than the U.S. dollar. Changes in the fair value of net investment hedges are recorded in the translation adjustment component of AOCI, effectively offsetting the translation gain or loss from consolidating the foreign subsidiaries onto the parent’s balance sheet. During the third quarter of 2014, we executed net investment hedges using foreign exchange forward contracts to hedge the translation exposure of the non-dollar equity invested in our foreign operations.

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Free-Standing Derivatives: We use free-standing derivatives to hedge the risk of changes in the fair value of residential MSRs, mortgage loan origination and purchase commitments and other interests held. We also categorize our customer accommodation derivatives and the related offsetting contracts as free-standing derivatives. Changes in the fair value of free-standing derivatives are recorded in earnings as a component of other non-interest income.

Balance Sheet Presentation

The following table summarizes the notional and fair values of our derivative instruments reported on our consolidated balance sheets as of September 30, 2014 and December 31, 2013. The fair value amounts are segregated by derivatives that are designated as accounting hedges and those that are not, and are further segregated by type of contract within those two categories.

Table 9.1: Derivative Assets and Liabilities at Fair Value



	September 30, 2014						December 31, 2013
	Notional or Contractual Amount		Derivative				Notional or Contractual Amount		Derivative
(Dollars in millions)	Notional or Contractual Amount		Assets		Liabilities		Notional or Contractual Amount		Assets		Liabilities
Derivatives designated as accounting hedges:
Interest rate contracts:
Fair value hedges	$	23,008	$	214	$	105	$	15,695	$	289	$	223
Cash flow hedges	20,100		4		65		12,825		0		149
Total interest rate contracts	43,108		218		170		28,520		289		372
Foreign exchange contracts:
Cash flow hedges	4,860		129		0		4,806		49		53
Net investment hedges	2,419		113		0		0		0		0
Total foreign exchange contracts	7,279		242		0		4,806		49		53
Total derivatives designated as accounting hedges	50,387		460		170		33,326		338		425
Derivatives not designated as accounting hedges:
Interest rate contracts covering:
MSRs⁽¹⁾	483		2		1		353		0		7
Customer accommodation	27,208		338		168		25,365		405		209
Other interest rate exposures⁽²⁾	2,657		31		17		1,864		29		17
Total interest rate contracts	30,348		371		186		27,582		434		233
Foreign exchange contracts	190		5		0		1,422		184		37
Other contracts	526		0		13		1,094		3		15
Total derivatives not designated as accounting hedges	31,064		376		199		30,098		621		285
Total derivatives	$	81,451	$	836	$	369	$	63,424	$	959	$	710

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⁽¹⁾	Includes interest rate swaps and To Be Announced (“TBA”) contracts used to hedge our MSR portfolio.


⁽²⁾	Other interest rate exposures include mortgage related derivatives.

Offsetting of Financial Assets and Liabilities

We execute the majority of our derivative transactions and repurchase agreements under master netting arrangements. Under our existing enforceable master netting arrangements, we generally have the right to offset exposure with the same counterparty. In addition, either counterparty can generally request the net settlement of all contracts through a single payment upon default on, or termination of, any one contract.

We present all of our derivative assets and liabilities and repurchase agreements on a gross basis on our consolidated balance sheets. The following table presents as of September 30, 2014 and December 31, 2013, the gross and net fair values of our derivative assets and liabilities and repurchase agreements, as well as the related offsetting amount permitted under the accounting standards for offsetting assets and liabilities. Under the accounting standard, gross positive fair values could be offset against gross negative fair values by counterparty pursuant to legally enforceable master netting agreements, if the netting presentation method is elected. The table also includes cash and non-cash collateral received or pledged associated with such arrangements. The collateral amounts related to derivative assets, derivative liabilities and repurchase agreements are limited to the extent of the related net derivative fair values or outstanding balances, thus instances of overcollateralization are not shown.

Table 9.2: Offsetting of Financial Assets and Financial Liabilities



	Gross Amounts		Offsetting Amounts		Net Amounts as Recognized		Offsetting Amounts Not Netted
(Dollars in millions)	Gross Amounts		Offsetting Amounts		Net Amounts as Recognized		Financial Instruments			Collateral Received ⁽¹⁾			Net Exposure⁽²⁾
As of September 30, 2014
Derivatives assets	$	836	$	0	$	836	$	(141	)	$	(425	)	$	270
As of December 31, 2013
Derivatives assets	$	959	$	0	$	959	$	(262	)	$	(450	)	$	247



	Gross Amounts		Offsetting Amounts		Net Amounts as Recognized		Offsetting Amounts Not Netted
(Dollars in millions)	Gross Amounts		Offsetting Amounts		Net Amounts as Recognized		Financial Instruments			Collateral Pledged				Net Exposure
As of September 30, 2014
Derivatives liabilities	$	369	$	0	$	369	$	(141	)	$	(170	)	⁽¹⁾	$	58
Repurchase agreements	940		0		940		0			(940		)		0
As of December 31, 2013
Derivatives liabilities	$	710	$	0	$	710	(262		)	$	(371	)	⁽¹⁾	$	77
Repurchase agreements	907		0		907		0			(907		)		0

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⁽¹⁾	When we receive or pledge collateral, we factor in accrued interest when calculating net positions with counterparties.


⁽²⁾	The majority of the net position relates to customer-accommodation derivatives. Customer-accommodation derivatives are cross-collateralized by the associated commercial loans and we do not require additional collateral on these transactions.

Credit Risk-Related Contingency Features and Collateral

Certain of our derivative contracts include provisions requiring that our debt maintain a credit rating of investment grade or above by each of the major credit rating agencies. In the event of a downgrade of our debt credit rating below investment grade, some of our derivative counterparties would have the right to terminate the derivative contract and close out the existing positions, or demand immediate and ongoing full overnight collateralization on derivative instruments in a net liability position. Certain of our derivative contracts may also allow, in the event of a downgrade of our debt credit rating of any kind, our derivative counterparties to demand additional collateralization on such derivative instruments in a net liability position. Of the $170 million of collateral pledged as of September 30, 2014, we have posted $118 million in cash collateral. We posted $371 million of cash collateral as of December 31, 2013. If our debt credit rating had fallen below investment grade, we would have been required to post an additional variation margin, which represents the impact of daily position mark-to-market calculations, of less than $1 million as of both September 30, 2014 and December 31, 2013. In addition, we would have been required to post independent margin of $56 million and $58 million as of September 30, 2014 and December 31, 2013, respectively, in compliance with the terms of certain of our swap agreements. The fair value of derivative instruments with credit-risk-related contingent features in a net liability position was less than $1 million and $1 million as of September 30, 2014 and December 31, 2013, respectively.

Derivative Counterparty Credit Risk

Derivative instruments contain an element of credit risk that arises from the potential failure of a counterparty to perform according to the contractual terms of the contract. Our exposure to derivative counterparty credit risk, at any point in time, is represented by the fair value of derivatives in a gain position, or derivative assets, assuming no recoveries of underlying collateral. To mitigate the risk of counterparty default, we maintain collateral agreements with certain derivative counterparties. These agreements typically require both parties to maintain collateral in the event the fair values of derivative financial instruments exceed established thresholds. We received cash collateral from derivatives counterparties totaling $362 million and $397 million as of September 30, 2014 and December 31, 2013, respectively. We also received securities from derivatives counterparties totaling $63 million and $53 million as of September 30, 2014 and December 31, 2013, respectively, which we have the ability to re-pledge.

We record counterparty credit risk valuation adjustments on our derivative assets to properly reflect the credit quality of the counterparty. We consider collateral and legally enforceable master netting agreements that mitigate our credit exposure to each counterparty in determining the counterparty credit risk valuation adjustment, which may be adjusted in future periods due to changes in the fair value of the derivative contract, collateral and creditworthiness of the counterparty. The cumulative counterparty credit risk valuation adjustment recorded on our consolidated balance sheets as a reduction in the derivative asset balance was $5 million and $7 million as of September 30, 2014 and December 31, 2013, respectively. We also adjust the fair value of our derivative liabilities to reflect the impact of our credit quality. We calculate this adjustment by comparing the spreads on our credit default swaps to the discount benchmark curve. The cumulative credit risk valuation adjustment related to our credit quality recorded on our consolidated balance sheets as a reduction in the derivative liability balance was $2 million and $6 million as of September 30, 2014 and December 31, 2013, respectively.

Income Statement Presentation and AOCI

The following tables summarize the impact of derivatives and the related hedged items on our consolidated statements of income and AOCI.

Fair Value Hedges and Free-Standing Derivatives

The net gains (losses) recognized in earnings related to derivatives in fair value hedging relationships and free-standing derivatives are presented below for the three and nine months ended September 30, 2014 and 2013:

Table 9.3: Gains and Losses on Fair Value Hedges and Free-Standing Derivatives



	Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in millions)	2014			2013			2014			2013
Derivatives designated as accounting hedges⁽¹⁾:
Fair value interest rate contracts:
(Losses) gains recognized in earnings on derivatives	$	(94	)	$	3		$	42		$	(409	)
Gains (losses) recognized in earnings on hedged items	110			(10		)	(5		)	380
Net fair value hedge ineffectiveness gains (losses)	16			(7		)	37			(29		)
Derivatives not designated as accounting hedges⁽¹⁾:
Interest rate contracts covering:
MSRs	1			0			14			(8		)
Customer accommodation	7			6			15			31
Other interest rate exposures	5			4			8			(5		)
Total interest rate contracts	13			10			37			18
Foreign exchange contracts	0			0			1			(4		)
Other contracts	(2		)	(18		)	(1		)	(25		)
Total gains (losses) on derivatives not designated as accounting hedges	11			(8		)	37			(11		)
Net derivative gains (losses) recognized in earnings	$	27		$	(15	)	$	74		$	(40	)

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⁽¹⁾	Amounts are recorded on our consolidated statements of income in other non-interest income.

Cash Flow and Net Investment Hedges

The table below shows the net gains (losses) related to derivatives designated as cash flow hedges and net investment hedges for the three and nine months ended September 30, 2014 and 2013:

Table 9.4: Gains and Losses on Derivatives Designated as Cash Flow Hedges and Net Investment Hedges



	Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in millions)	2014			2013			2014			2013
Gains (losses) recorded in AOCI:
Cash flow hedges:
Interest rate contracts	$	(34	)	$	65		$	112		$	(82	)
Foreign exchange contracts	(5		)	(6		)	(16		)	(16		)
Subtotal	(39		)	59			96			(98		)
Net investment hedges:
Foreign exchange contracts	71			0			71			0
Net derivatives gains (losses) recognized in AOCI	$	32		$	59		$	167		$	(98	)
Gains (losses) recorded in earnings:
Cash flow hedges:
Gains (losses) reclassified from AOCI into earnings:
Interest rate contracts⁽¹⁾	$	34		$	14		$	90		$	40
Foreign exchange contracts⁽²⁾	(5		)	(8		)	(16		)	(17		)
Subtotal	29			6			74			23
Gains (losses) recognized in earnings due to ineffectiveness:
Interest rate contracts⁽²⁾	(1		)	1			0			0
Net derivative gains recognized in earnings	$	28		$	7		$	74		$	23

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⁽¹⁾	Amounts reclassified are recorded on our consolidated statements of income in interest income or interest expense.


⁽²⁾	Amounts reclassified are recorded on our consolidated statements of income in other non-interest income.

We expect to reclassify net after-tax losses of $22 million recorded in AOCI as of September 30, 2014, related to derivatives designated as cash flow hedges to earnings over the next 12 months, which we expect to offset against the cash flows associated with the hedged forecasted transactions. The maximum length of time over which forecasted transactions were hedged was five years as of September 30, 2014. The amount we expect to reclassify into earnings may change as a result of changes in market conditions and ongoing actions taken as part of our overall risk management strategy.