Annual report pursuant to Section 13 and 15(d)

Derivatives

v2.4.0.6
Derivatives
 12 Months Ended
Dec. 31, 2012
Derivatives [Abstract]  
Derivative Instruments and Hedging Activities Disclosure
Derivatives
Derivative Balances
Derivatives are entered into on behalf of customers, for trading, or to support risk management activities. Derivatives used in risk management activities include derivatives that may or may not be designated in qualifying hedge accounting relationships. Derivatives that are not designated in qualifying hedge accounting relationships are referred to as other risk management derivatives. For additional information on the Corporation’s derivatives and hedging activities, see Note 1 – Summary of Significant Accounting Principles. The following tables present derivative instruments included on the Corporation’s Consolidated Balance Sheet in derivative assets and liabilities at December 31, 2012 and 2011. Balances are presented on a gross basis, prior to the application of counterparty and cash collateral netting. Total derivative assets and liabilities are adjusted on an aggregate basis to take into consideration the effects of legally enforceable master netting agreements and have been reduced by the cash collateral received or paid.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
Gross Derivative Assets
 
Gross Derivative Liabilities
(Dollars in billions)
Contract/
Notional (1)
 
Trading Derivatives and Other Risk Management Derivatives
 
Qualifying
Accounting
Hedges
 
Total
 
Trading Derivatives and Other Risk Management Derivatives
 
Qualifying
Accounting
Hedges
 
Total
Interest rate contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
$
34,667.4

 
$
1,075.4

 
$
13.8

 
$
1,089.2

 
$
1,062.6

 
$
4.7

 
$
1,067.3

Futures and forwards
11,950.5

 
2.8

 
—

 
2.8

 
2.7

 
—

 
2.7

Written options
2,343.5

 
—

 
—

 
—

 
106.0

 
—

 
106.0

Purchased options
2,162.6

 
105.5

 
—

 
105.5

 
—

 
—

 
—

Foreign exchange contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
2,489.0

 
47.4

 
1.4

 
48.8

 
53.2

 
1.8

 
55.0

Spot, futures and forwards
3,023.0

 
31.5

 
0.4

 
31.9

 
30.5

 
0.8

 
31.3

Written options
363.3

 
—

 
—

 
—

 
7.3

 
—

 
7.3

Purchased options
321.8

 
6.5

 
—

 
6.5

 
—

 
—

 
—

Equity contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
127.1

 
1.6

 
—

 
1.6

 
2.0

 
—

 
2.0

Futures and forwards
58.4

 
1.0

 
—

 
1.0

 
1.0

 
—

 
1.0

Written options
295.3

 
—

 
—

 
—

 
20.2

 
—

 
20.2

Purchased options
271.0

 
20.4

 
—

 
20.4

 
—

 
—

 
—

Commodity contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
60.5

 
2.5

 
0.1

 
2.6

 
4.0

 
—

 
4.0

Futures and forwards
498.9

 
4.8

 
—

 
4.8

 
2.7

 
—

 
2.7

Written options
166.4

 
—

 
—

 
—

 
7.4

 
—

 
7.4

Purchased options
168.2

 
7.1

 
—

 
7.1

 
—

 
—

 
—

Credit derivatives
 

 
 

 
 

 
 

 
 

 
 

 
 

Purchased credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

 
 

Credit default swaps
1,559.5

 
35.6

 
—

 
35.6

 
22.1

 
—

 
22.1

Total return swaps/other
43.5

 
2.5

 
—

 
2.5

 
2.9

 
—

 
2.9

Written credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

 
 

Credit default swaps
1,531.5

 
23.0

 
—

 
23.0

 
32.6

 
—

 
32.6

Total return swaps/other
68.8

 
0.2

 
—

 
0.2

 
0.3

 
—

 
0.3

Gross derivative assets/liabilities
 

 
$
1,367.8

 
$
15.7

 
$
1,383.5

 
$
1,357.5

 
$
7.3

 
$
1,364.8

Less: Legally enforceable master netting agreements
 

 
 

 
 

 
(1,271.9
)
 
 

 
 

 
(1,271.9
)
Less: Cash collateral received/paid
 

 
 

 
 

 
(58.1
)
 
 

 
 

 
(46.9
)
Total derivative assets/liabilities
 

 
 

 
 

 
$
53.5

 
 

 
 

 
$
46.0

(1) 
Represents the total contract/notional amount of derivative assets and liabilities outstanding.

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2011
 
 
 
Gross Derivative Assets
 
Gross Derivative Liabilities
(Dollars in billions)
Contract/
Notional (1)
 
Trading Derivatives and Other Risk Management Derivatives
 
Qualifying
Accounting
Hedges
 
Total
 
Trading Derivatives and Other Risk Management Derivatives
 
Qualifying
Accounting
Hedges
 
Total
Interest rate contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
$
40,473.7

 
$
1,490.7

 
$
15.9

 
$
1,506.6

 
$
1,473.0

 
$
12.3

 
$
1,485.3

Futures and forwards
12,105.8

 
2.9

 
0.2

 
3.1

 
3.4

 
—

 
3.4

Written options
2,534.0

 
—

 
—

 
—

 
117.8

 
—

 
117.8

Purchased options
2,467.2

 
120.0

 
—

 
120.0

 
—

 
—

 
—

Foreign exchange contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
2,381.6

 
48.3

 
2.6

 
50.9

 
58.9

 
2.2

 
61.1

Spot, futures and forwards
2,548.8

 
37.2

 
1.3

 
38.5

 
39.2

 
0.3

 
39.5

Written options
368.5

 
—

 
—

 
—

 
9.4

 
—

 
9.4

Purchased options
341.0

 
9.0

 
—

 
9.0

 
—

 
—

 
—

Equity contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
75.5

 
1.5

 
—

 
1.5

 
1.7

 
—

 
1.7

Futures and forwards
52.1

 
1.8

 
—

 
1.8

 
1.5

 
—

 
1.5

Written options
367.1

 
—

 
—

 
—

 
17.7

 
—

 
17.7

Purchased options
360.2

 
19.6

 
—

 
19.6

 
—

 
—

 
—

Commodity contracts
 

 
 

 
 

 
 

 
 

 
 

 
 

Swaps
73.8

 
4.9

 
0.1

 
5.0

 
5.9

 
—

 
5.9

Futures and forwards
470.5

 
5.3

 
—

 
5.3

 
3.2

 
—

 
3.2

Written options
142.3

 
—

 
—

 
—

 
9.5

 
—

 
9.5

Purchased options
141.3

 
9.5

 
—

 
9.5

 
—

 
—

 
—

Credit derivatives
 

 
 

 
 

 
 

 
 

 
 

 
 

Purchased credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

 
 

Credit default swaps
1,944.8

 
95.8

 
—

 
95.8

 
13.8

 
—

 
13.8

Total return swaps/other
17.5

 
0.6

 
—

 
0.6

 
0.3

 
—

 
0.3

Written credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

 
 

Credit default swaps
1,885.9

 
14.1

 
—

 
14.1

 
90.5

 
—

 
90.5

Total return swaps/other
17.8

 
0.5

 
—

 
0.5

 
0.7

 
—

 
0.7

Gross derivative assets/liabilities
 

 
$
1,861.7

 
$
20.1

 
$
1,881.8

 
$
1,846.5

 
$
14.8

 
$
1,861.3

Less: Legally enforceable master netting agreements
 

 
 

 
 

 
(1,749.9
)
 
 

 
 

 
(1,749.9
)
Less: Cash collateral received/paid
 

 
 

 
 

 
(58.9
)
 
 

 
 

 
(51.9
)
Total derivative assets/liabilities
 

 
 

 
 

 
$
73.0

 
 

 
 

 
$
59.5

(1) 
Represents the total contract/notional amount of derivative assets and liabilities outstanding.
ALM and Risk Management Derivatives
The Corporation’s ALM and risk management activities include the use of derivatives to mitigate risk to the Corporation including derivatives designated in qualifying hedge accounting relationships and derivatives used in other risk management activities. Interest rate, foreign exchange, equity, commodity and credit contracts are utilized in the Corporation’s ALM and risk management activities.
The Corporation maintains an overall interest rate risk management strategy that incorporates the use of interest rate contracts, which are generally non-leveraged generic interest rate and basis swaps, options, futures and forwards, to minimize significant fluctuations in earnings that are caused by interest rate volatility. The Corporation’s goal is to manage interest rate sensitivity and volatility so that movements in interest rates do not significantly adversely affect earnings or capital. As a result of interest rate fluctuations, hedged fixed-rate assets and liabilities appreciate or depreciate in fair value. Gains or losses on the derivative instruments that are linked to the hedged fixed-rate assets and liabilities are expected to substantially offset this unrealized appreciation or depreciation.
Market risk, including interest rate risk, can be substantial in the mortgage business. Market risk is the risk that values of mortgage assets or revenues will be adversely affected by changes in market conditions such as interest rate movements. To mitigate the interest rate risk in mortgage banking production income, the Corporation utilizes forward loan sale commitments and other derivative instruments including purchased options and certain debt securities. The Corporation also utilizes derivatives such as interest rate options, interest rate swaps, forward settlement contracts and Eurodollar futures to hedge certain market risks of MSRs. For additional information on MSRs, see Note 24 – Mortgage Servicing Rights.
The Corporation uses foreign exchange contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities, as well as the Corporation’s investments in non-U.S. subsidiaries. Foreign exchange contracts, which include spot and forward contracts, 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 loss on these contracts will increase or decrease over their respective lives as currency exchange and interest rates fluctuate.
The Corporation enters into derivative commodity contracts such as futures, swaps, options and forwards as well as non-derivative commodity contracts to provide price risk management services to customers or to manage price risk associated with its physical and financial commodity positions. The non-derivative commodity contracts and physical inventories of commodities expose the Corporation to earnings volatility. Cash flow and fair value accounting hedges provide a method to mitigate a portion of this earnings volatility.
The Corporation purchases credit derivatives to manage credit risk related to certain funded and unfunded credit exposures. Credit derivatives include credit default swaps (CDS), total return swaps and swaptions. These derivatives are recorded on the Corporation’s Consolidated Balance Sheet at fair value with changes in fair value recorded in other income (loss).
Derivatives Designated as Accounting Hedges
The Corporation uses various types of interest rate, commodity and foreign exchange derivative contracts to protect against changes in the fair value of its assets and liabilities due to fluctuations in interest rates, commodity prices and exchange rates (fair value hedges). The Corporation also uses these types of contracts and equity derivatives to protect against changes in the cash flows of its assets and liabilities, and other forecasted transactions (cash flow hedges). The Corporation hedges its net investment in consolidated non-U.S. operations determined to have functional currencies other than the U.S. dollar using forward exchange contracts and cross-currency basis swaps, and by issuing foreign currency-denominated debt (net investment hedges).
Fair Value Hedges
The table below summarizes certain information related to fair value hedges for 2012, 2011 and 2010, including hedges of interest rate risk on long-term debt that were acquired as part of a business combination and redesignated. At redesignation, the fair value of the derivatives was negative. As the derivatives mature, the fair value will approach zero. As a result, ineffectiveness may occur and the fair value changes in the derivatives and the long-term debt being hedged may be directionally the same in certain scenarios. Based on a regression analysis, the derivatives continue to be highly effective at offsetting changes in the fair value of the long-term debt attributable to interest rate risk.
 
 
 
Derivatives Designated as Fair Value Hedges
 
 
 
 
 
 
 
 
 
 
 
Gains (losses)
2012
(Dollars in millions)
Derivative
 
Hedged
Item
 
Hedge
Ineffectiveness
Interest rate risk on long-term debt (1)
$
(195
)
 
$
(770
)
 
$
(965
)
Interest rate and foreign currency risk on long-term debt (1)
(1,482
)
 
1,225

 
(257
)
Interest rate risk on AFS securities (2)
(4
)
 
91

 
87

Commodity price risk on commodity inventory (3)
(6
)
 
6

 
—

Total
$
(1,687
)
 
$
552

 
$
(1,135
)
 
 
 
 
 
 
 
2011
Interest rate risk on long-term debt (1)
$
4,384

 
$
(4,969
)
 
$
(585
)
Interest rate and foreign currency risk on long-term debt (1)
780

 
(1,057
)
 
(277
)
Interest rate risk on AFS securities (2)
(11,386
)
 
10,490

 
(896
)
Commodity price risk on commodity inventory (3)
16

 
(16
)
 
—

Total
$
(6,206
)
 
$
4,448

 
$
(1,758
)
 
 
 
 
 
 
 
2010
Interest rate risk on long-term debt (1)
$
2,952

 
$
(3,496
)
 
$
(544
)
Interest rate and foreign currency risk on long-term debt (1)
(463
)
 
130

 
(333
)
Interest rate risk on AFS securities (2)
(2,577
)
 
2,667

 
90

Commodity price risk on commodity inventory (3)
19

 
(19
)
 
—

Total
$
(69
)
 
$
(718
)
 
$
(787
)
(1) 
Amounts are recorded in interest expense on long-term debt and in other income (loss).
(2) 
Amounts are recorded in interest income on debt securities.
(3) 
Amounts relating to commodity inventory are recorded in trading account profits.

Cash Flow and Net Investment Hedges
The table below summarizes certain information related to cash flow hedges and net investment hedges for 2012, 2011 and 2010. During the next 12 months, net losses in accumulated OCI of $981 million ($618 million after-tax) on derivative instruments that qualify as cash flow hedges are expected to be reclassified into earnings. These net losses reclassified into earnings are expected to primarily reduce net interest income related to the respective hedged items. Amounts related to commodity price risk reclassified from accumulated OCI are recorded in trading account profits with the underlying hedged item. Amounts related to price risk on restricted stock awards reclassified from accumulated OCI are recorded in personnel expense.
Amounts related to foreign exchange risk recognized in accumulated OCI on derivatives exclude pre-tax losses of $7 million, and pre-tax gains of $82 million and $192 million related to long-term debt designated as a net investment hedge for 2012, 2011 and 2010, respectively.
 
 
 
 
 
 
Derivatives Designated as Cash Flow and Net Investment Hedges
 
 
 
 
 
 
 
 
 
 
 
 
2012
(Dollars in millions, amounts pre-tax)
Gains (losses)
Recognized in
Accumulated OCI
on Derivatives
 
Gains (losses)
in Income
Reclassified from
Accumulated OCI
 
Hedge
Ineffectiveness and
Amounts Excluded
from Effectiveness
Testing (1)
Cash flow hedges
 

 
 

 
 

Interest rate risk on variable rate portfolios
$
10

 
$
(957
)
 
$
—

Price risk on restricted stock awards
420

 
(78
)
 
—

Total
$
430

 
$
(1,035
)
 
$
—

Net investment hedges
 

 
 

 
 

Foreign exchange risk
$
(771
)
 
$
(26
)
 
$
(269
)
 
 
 
 
 
 
 
2011
Cash flow hedges
 

 
 

 
 

Interest rate risk on variable rate portfolios
$
(2,079
)
 
$
(1,392
)
 
$
(8
)
Commodity price risk on forecasted purchases and sales
(3
)
 
6

 
(3
)
Price risk on restricted stock awards
(408
)
 
(231
)
 
—

Total
$
(2,490
)
 
$
(1,617
)
 
$
(11
)
Net investment hedges
 

 
 

 
 

Foreign exchange risk
$
1,055

 
$
384

 
$
(572
)
 
 
 
 
 
 
 
2010
Cash flow hedges
 

 
 

 
 

Interest rate risk on variable rate portfolios
$
(1,876
)
 
$
(410
)
 
$
(30
)
Commodity price risk on forecasted purchases and sales
32

 
25

 
11

Price risk on restricted stock awards
(97
)
 
(33
)
 
—

Price risk on equity investments included in AFS securities
186

 
(226
)
 
—

Total
$
(1,755
)
 
$
(644
)
 
$
(19
)
Net investment hedges
 

 
 

 
 

Foreign exchange risk
$
(482
)
 
$
—

 
$
(315
)
(1) 
Amounts related to derivatives designated as cash flow hedges represent hedge ineffectiveness and amounts related to net investment hedges represent amounts excluded from effectiveness testing.
The Corporation enters into equity total return swaps to hedge a portion of RSUs granted to certain employees as part of their compensation. Certain awards contain clawback provisions which permit the Corporation to cancel all or a portion of the award under specified circumstances, and certain awards may be settled in cash. These RSUs are accrued as liabilities over the vesting period and adjusted to fair value based on changes in the share price of the Corporation’s common stock. From time to time, the Corporation may enter into equity derivatives to minimize the change in the expense driven by fluctuations in the share price of the common stock during the vesting period of any RSUs that may be granted, if any, subject to similar or other terms and conditions. Certain of these derivatives are designated as cash flow hedges of unrecognized unvested awards with changes in fair value of the hedge recorded in accumulated OCI and reclassified into earnings in the same period as the RSUs affect earnings. The remaining derivatives are other risk management derivatives and changes in fair value are recorded in personnel expense. For more information on RSUs and related hedges, see Note 19 – Stock-based Compensation Plans.

Other Risk Management Derivatives
Other risk management derivatives are used by the Corporation to reduce certain risk exposures. These derivatives are not qualifying accounting hedges because either they did not qualify for or were not designated as accounting hedges. The table below presents gains (losses) on these derivatives for 2012, 2011 and 2010. These gains (losses) are largely offset by the income or expense that is recorded on the hedged item.
 
 
 
 
 
 
Other Risk Management Derivatives
 
 
 
 
 
 
 
 
 
 
 
Gains (losses)
 
 
 
 
 
 
 
 
 
 
 
(Dollars in millions)
2012
 
2011
 
2010
Price risk on mortgage banking production income (1, 2)
$
3,022

 
$
2,852

 
$
9,109

Market-related risk on mortgage banking servicing income (1)
2,000

 
3,612

 
3,878

Credit risk on loans (3)
(95
)
 
30

 
(121
)
Interest rate and foreign currency risk on long-term debt and other foreign exchange transactions (4)
424

 
(48
)
 
(2,080
)
Price risk on restricted stock awards (5)
1,008

 
(610
)
 
(151
)
Other
58

 
281

 
42

Total
$
6,417

 
$
6,117

 
$
10,677

(1) 
Net gains on these derivatives are recorded in mortgage banking income (loss).
(2) 
Includes net gains on interest rate lock commitments related to the origination of mortgage loans that are held-for-sale, which are considered derivative instruments, of $3.0 billion, $3.8 billion and $8.7 billion for 2012, 2011 and 2010, respectively.
(3) 
Net gains (losses) on these derivatives are recorded in other income (loss).
(4) 
The majority of the balance is related to the revaluation of derivatives used to mitigate risk related to foreign currency-denominated debt which is recorded in other income (loss). The offsetting revaluation of the foreign currency-denominated debt, while not included in the table above, is also recorded in other income (loss).
(5) 
Gains (losses) on these derivatives are recorded in personnel expense.
Sales and Trading Revenue
The Corporation enters into trading derivatives to facilitate client transactions, for principal trading purposes, and to manage risk exposures arising from trading account assets and liabilities. It is the Corporation’s policy to include these derivative instruments in its trading activities which include derivatives and non-derivative cash instruments. The resulting risk from these derivatives is managed on a portfolio basis as part of the Corporation’s Global Markets business segment. The related sales and trading revenue generated within Global Markets is recorded in various income statement line items including trading account profits and net interest income as well as other revenue categories. However, the majority of income related to derivative instruments is recorded in trading account profits.
Sales and trading revenue includes changes in the fair value and realized gains and losses on the sales of trading and other assets, net interest income, and fees primarily from commissions on equity securities. Revenue is generated by the difference in the client price for an instrument and the price at which the trading desk can execute the trade in the dealer market. For equity securities, commissions related to purchases and sales are recorded in other income (loss). Changes in the fair value of these securities are included in trading account profits. For debt securities, revenue, with the exception of interest associated with the debt securities, is typically included in trading account profits. Unlike commissions for equity securities, the initial revenue related to broker/dealer services for debt securities is typically included in the pricing of the instrument rather than being charged through separate fee arrangements. Therefore, this revenue is recorded in trading account profits as part of the initial mark to fair value. For derivatives, all revenue is included in trading account profits. In transactions where the Corporation acts as agent, which include exchange-traded futures and options, fees are recorded in other income (loss).
Gains (losses) on certain instruments, primarily loans, that the Global Markets business segment shares with Global Banking are not considered trading instruments and are excluded from sales and trading revenue in their entirety.

The table below, which includes both derivatives and non-derivative cash instruments, identifies the amounts in the respective income statement line items attributable to the Corporation’s sales and trading revenue in Global Markets, categorized by primary risk, for 2012, 2011 and 2010. The difference between total trading account profits in the table below and in the Corporation’s Consolidated Statement of Income represents trading activities in business segments other than Global Markets. Global Markets results in Note 26 – Business Segment Information are presented on a fully taxable-equivalent (FTE) basis. The table below is not presented on a FTE basis.
 
 
 
 
 
 
 
 
Sales and Trading Revenue
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2012
(Dollars in millions)
Trading Account Profits
 
Net Interest Income
 
Other (1)
 
Total
Interest rate risk
$
580

 
$
1,040

 
$
(5
)
 
$
1,615

Foreign exchange risk
909

 
5

 
7

 
921

Equity risk
1,181

 
(57
)
 
1,890

 
3,014

Credit risk
2,496

 
2,321

 
961

 
5,778

Other risk
540

 
(219
)
 
(42
)
 
279

Total sales and trading revenue
$
5,706

 
$
3,090

 
$
2,811

 
$
11,607

 
 
 
 
 
 
 
 
 
2011
Interest rate risk
$
2,118

 
$
923

 
$
(63
)
 
$
2,978

Foreign exchange risk
1,088

 
8

 
(10
)
 
1,086

Equity risk
1,482

 
128

 
2,346

 
3,956

Credit risk
1,096

 
2,604

 
553

 
4,253

Other risk
633

 
(184
)
 
(72
)
 
377

Total sales and trading revenue
$
6,417

 
$
3,479

 
$
2,754

 
$
12,650

 
 
 
 
 
 
 
 
 
2010
Interest rate risk
$
2,032

 
$
659

 
$
38

 
$
2,729

Foreign exchange risk
903

 
—

 
(9
)
 
894

Equity risk
1,650

 
16

 
2,447

 
4,113

Credit risk
4,592

 
3,557

 
266

 
8,415

Other risk
447

 
(172
)
 
(4
)
 
271

Total sales and trading revenue
$
9,624

 
$
4,060

 
$
2,738

 
$
16,422

(1) 
Represents amounts in investment and brokerage services and other income (loss) that are recorded in Global Markets and included in the definition of sales and trading revenue. Includes investment and brokerage services revenue of $1.8 billion, $2.2 billion and $2.3 billion for 2012, 2011 and 2010, respectively, primarily included in equity risk.
Credit Derivatives
The Corporation enters into credit derivatives primarily to facilitate client transactions and to manage credit risk exposures. Credit derivatives derive value based on an underlying third-party referenced obligation or a portfolio of referenced obligations and generally require the Corporation, as the seller of credit protection, to make payments to a buyer upon the occurrence of a pre-defined credit event. Such credit events generally include bankruptcy of the referenced credit entity and failure to pay under the obligation, as well as acceleration of indebtedness and payment repudiation or moratorium. For credit derivatives based on a portfolio of referenced credits or credit indices, the Corporation may not be required to make payment until a specified amount of loss has occurred and/or may only be required to make payment up to a specified amount.

Credit derivative instruments where the Corporation is the seller of credit protection and their expiration are summarized at December 31, 2012 and 2011 in the table below. These instruments are classified as investment and non-investment grade based on the credit quality of the underlying referenced obligation. The Corporation considers ratings of BBB- or higher as investment grade. Non-investment grade includes non-rated credit derivative instruments.
 
 
 
 
 
 
 
 
 
 
Credit Derivative Instruments
 
 
 
 
December 31, 2012
 
Carrying Value
(Dollars in millions)
Less than
One Year
 
One to
Three Years
 
Three to
Five Years
 
Over Five
Years
 
Total
Credit default swaps:
 

 
 

 
 

 
 

 
 

Investment grade
$
52

 
$
757

 
$
5,595

 
$
2,903

 
$
9,307

Non-investment grade
923

 
4,403

 
7,030

 
10,959

 
23,315

Total
975

 
5,160

 
12,625

 
13,862

 
32,622

Total return swaps/other:
 

 
 

 
 

 
 

 
 

Investment grade
39

 
—

 
—

 
—

 
39

Non-investment grade
57

 
104

 
39

 
37

 
237

Total
96

 
104

 
39

 
37

 
276

Total credit derivatives
$
1,071

 
$
5,264

 
$
12,664

 
$
13,899

 
$
32,898

Credit-related notes: (1)
 

 
 

 
 

 
 

 
 

Investment grade
$
4

 
$
12

 
$
441

 
$
3,849

 
$
4,306

Non-investment grade
116

 
161

 
314

 
1,425

 
2,016

Total credit-related notes
$
120

 
$
173

 
$
755

 
$
5,274

 
$
6,322

 
Maximum Payout/Notional
Credit default swaps:
 

 
 

 
 

 
 

 
 

Investment grade
$
260,177

 
$
349,125

 
$
500,038

 
$
90,453

 
$
1,199,793

Non-investment grade
79,861

 
99,043

 
110,248

 
42,559

 
331,711

Total
340,038

 
448,168

 
610,286

 
133,012

 
1,531,504

Total return swaps/other:
 

 
 

 
 

 
 

 
 

Investment grade
43,536

 
15

 
—

 
—

 
43,551

Non-investment grade
5,566

 
11,028

 
7,631

 
1,035

 
25,260

Total
49,102

 
11,043

 
7,631

 
1,035

 
68,811

Total credit derivatives
$
389,140

 
$
459,211

 
$
617,917

 
$
134,047

 
$
1,600,315

 
December 31, 2011
(Dollars in millions)
Carrying Value
Credit default swaps:
 

 
 

 
 

 
 

 
 

Investment grade
$
795

 
$
5,011

 
$
17,271

 
$
7,325

 
$
30,402

Non-investment grade
4,236

 
11,438

 
18,072

 
26,339

 
60,085

Total
5,031

 
16,449

 
35,343

 
33,664

 
90,487

Total return swaps/other:
 

 
 

 
 

 
 

 
 

Investment grade
—

 
—

 
30

 
1

 
31

Non-investment grade
522

 
2

 
33

 
128

 
685

Total
522

 
2

 
63

 
129

 
716

Total credit derivatives
$
5,553

 
$
16,451

 
$
35,406

 
$
33,793

 
$
91,203

Credit-related notes: (1)
 

 
 

 
 

 
 

 
 

Investment grade
$
—

 
$
7

 
$
208

 
$
2,947

 
$
3,162

Non-investment grade
127

 
85

 
132

 
1,732

 
2,076

Total credit-related notes
$
127

 
$
92

 
$
340

 
$
4,679

 
$
5,238

 
Maximum Payout/Notional
Credit default swaps:
 

 
 

 
 

 
 

 
 

Investment grade
$
182,137

 
$
401,914

 
$
477,924

 
$
127,570

 
$
1,189,545

Non-investment grade
133,624

 
228,327

 
186,522

 
147,926

 
696,399

Total
315,761

 
630,241

 
664,446

 
275,496

 
1,885,944

Total return swaps/other:
 

 
 

 
 

 
 

 
 

Investment grade
—

 
—

 
9,116

 
—

 
9,116

Non-investment grade
305

 
2,023

 
4,918

 
1,476

 
8,722

Total
305

 
2,023

 
14,034

 
1,476

 
17,838

Total credit derivatives
$
316,066

 
$
632,264

 
$
678,480

 
$
276,972

 
$
1,903,782

(1) 
For credit-related notes, maximum payout/notional is the same as carrying value.

The notional amount represents the maximum amount payable by the Corporation for most credit derivatives. However, the Corporation does not monitor its exposure to credit derivatives based solely on the notional amount because this measure does not take into consideration the probability of occurrence. As such, the notional amount is not a reliable indicator of the Corporation’s exposure to these contracts. Instead, a risk framework is used to define risk tolerances and establish limits to help ensure that certain credit risk-related losses occur within acceptable, predefined limits.
The Corporation manages its market risk exposure to credit derivatives by entering into a variety of offsetting derivative contracts and security positions. For example, in certain instances, the Corporation may purchase credit protection with identical underlying referenced names to offset its exposure. The carrying value and notional amount of written credit derivatives for which the Corporation held purchased credit derivatives with identical underlying referenced names and terms at December 31, 2012 was $20.7 billion and $1.1 trillion compared to $48.0 billion and $1.0 trillion at December 31, 2011.
Credit-related notes in the table on page 180 include investments in securities issued by CDO, collateralized loan obligation (CLO) and credit-linked note vehicles. These instruments are primarily classified as trading securities. The carrying value of these instruments equals the Corporation’s maximum exposure to loss. The Corporation is not obligated to make any payments to the entities under the terms of the securities owned. The Corporation discloses internal categorizations of investment grade and non-investment grade consistent with how risk is managed for these instruments.
Credit-related Contingent Features and Collateral
The Corporation executes the majority of its derivative contracts in the OTC market with large, international financial institutions, including broker/dealers and, to a lesser degree, with a variety of non-financial companies. Substantially all of the derivative transactions are executed on a daily margin basis. Therefore, events such as a credit rating downgrade (depending on the ultimate rating level) or a breach of credit covenants would typically require an increase in the amount of collateral required of the counterparty, where applicable, and/or allow the Corporation to take additional protective measures such as early termination of all trades. Further, as previously discussed on page 174, the Corporation enters into legally enforceable master netting agreements which reduce risk by permitting the closeout and netting of transactions with the same counterparty upon the occurrence of certain events.
A majority of the Corporation’s derivative contracts contain credit risk related contingent features, primarily in the form of International Swaps and Derivatives Association, Inc. (ISDA) master netting agreements and credit support documentation that enhance the creditworthiness of these instruments compared to other obligations of the respective counterparty with whom the Corporation has transacted. These contingent features may be for the benefit of the Corporation as well as its counterparties with respect to changes in the Corporation’s creditworthiness and the mark-to-market exposure under the derivative transactions. At December 31, 2012 and 2011, the Corporation held cash and securities collateral of $85.6 billion and $87.7 billion, and posted cash and securities collateral of $74.1 billion and $86.5 billion in the normal course of business under derivative agreements.
In connection with certain OTC derivative contracts and other trading agreements, the Corporation can be required to provide additional collateral or to terminate transactions with certain counterparties in the event of a downgrade of the senior debt ratings of the Corporation or certain subsidiaries. The amount of additional collateral required depends on the contract and is usually a fixed incremental amount and/or the market value of the exposure.
At December 31, 2012, the amount of collateral, calculated based on the terms of the contracts, that the Corporation and certain subsidiaries could be required to post to counterparties but had not yet posted to counterparties was approximately $2.2 billion, comprised of $721 million for BANA and $1.5 billion for Merrill Lynch & Co., Inc. (Merrill Lynch) and certain of its subsidiaries.
Some counterparties are currently able to unilaterally terminate certain contracts, or the Corporation or certain subsidiaries may be required to take other action such as find a suitable replacement or obtain a guarantee. At December 31, 2012, the current liability recorded for these derivative contracts was $1.7 billion, against which the Corporation and certain subsidiaries had posted approximately $1.6 billion of collateral.
At December 31, 2012, if the rating agencies had downgraded their long-term senior debt ratings for the Corporation or certain subsidiaries by one incremental notch, the amount of additional collateral contractually required by derivative contracts and other trading agreements would have been approximately $3.3 billion comprised of $2.9 billion for BANA and $418 million for Merrill Lynch and certain of its subsidiaries. If the agencies had downgraded their long-term senior debt ratings for these entities by a second incremental notch, approximately $4.4 billion in additional incremental collateral comprised of $455 million for BANA and $4.0 billion for Merrill Lynch and certain of its subsidiaries would have been required.
Also, if the rating agencies had downgraded their long-term senior debt ratings for the Corporation or certain subsidiaries by one incremental notch, the derivative liability that would be subject to unilateral termination by counterparties as of December 31, 2012 was $3.8 billion, against which $3.0 billion of collateral has been posted. If the rating agencies had downgraded their long-term senior debt ratings for the Corporation and certain subsidiaries by a second incremental notch, the derivative liability that would be subject to unilateral termination by counterparties as of December 31, 2012 was an incremental $1.7 billion, against which $1.1 billion of collateral has been posted.
Valuation Adjustments on Derivatives
The Corporation records credit risk valuation adjustments on derivatives in order to properly reflect the credit quality of the counterparties and its own credit quality. The Corporation calculates valuation adjustments on derivatives based on a modeled expected exposure that incorporates current market risk factors. The exposure also takes into consideration credit mitigants such as enforceable master netting agreements and collateral. CDS spread data is used to estimate the default probabilities and severities that are applied to the exposures. Where no observable credit default data is available for counterparties, the Corporation uses proxies and other market data to estimate default probabilities and severity.
Valuation adjustments on derivatives are affected by changes in market spreads, non-credit related market factors such as interest rate and currency changes that affect the expected exposure, and other factors like changes in collateral arrangements and partial payments. Credit spread changes and non-credit factors can move independently. For example, for an interest rate swap, changes in interest rates may increase the expected exposure which would increase the counterparty credit valuation adjustment (CVA). Independently, counterparty credit spreads may tighten, which would result in an offsetting decrease to CVA.
The Corporation may enter into risk management activities to offset market driven exposures. The Corporation often hedges the counterparty spread risk in CVA with CDS and often hedges the other market risks in both CVA and debit valuation adjustments (DVA) primarily with currency and interest rate swaps. Since the components of the valuation adjustments on derivatives move independently and the Corporation may not hedge all of the market driven exposures, the effect of a hedge may increase the gross valuation adjustments on derivatives or may result in a gross positive valuation adjustment on derivatives becoming a negative adjustment (or the reverse).
During 2012, the Corporation refined its methodology for calculating valuation adjustments on derivatives on a prospective basis. The Corporation no longer considers the probability of default for both the counterparty and the Corporation when calculating the counterparty CVA and DVA and now only considers the probability of the counterparty defaulting for CVA and the Corporation defaulting for DVA.
The table below presents CVA and DVA gains (losses) for the Corporation on a gross and net of hedge basis, which are recorded in trading account profits.
 
 
 
 
 
 
Valuation Adjustments on Derivatives
 
 
 
 
 
 
 
2012
 
2011
(Dollars in millions)
Gross
Net
 
Gross
Net
Derivative assets (CVA) (1)
$
1,022

$
291

 
$
(1,863
)
$
(606
)
Derivative liabilities (DVA) (2)
(2,212
)
(2,477
)
 
1,385

1,000

(1) 
At December 31, 2012 and 2011, the cumulative CVA reduced the derivative assets balance by $2.4 billion and $2.8 billion.
(2) 
At December 31, 2012 and 2011, the Corporation’s cumulative DVA reduced the derivative liabilities balance by $807 million and $2.4 billion.