Quarterly report pursuant to Section 13 or 15(d)

Derivatives

v2.4.0.6
Derivatives
 9 Months Ended
Sep. 30, 2012
Derivatives [Abstract]  
Derivative Instruments and Hedging Activities Disclosure
NOTE 3 – Derivatives
 
Derivative Balances

Derivatives are entered into on behalf of customers, for trading, as economic hedges or as qualifying accounting hedges. For additional information on the Corporation’s derivatives and hedging activities, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements of the Corporation's 2011 Annual Report on Form 10-K. The following tables present derivative instruments included on the Corporation’s Consolidated Balance Sheet in derivative assets and liabilities at September 30, 2012 and December 31, 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.

 
September 30, 2012
 
 
 
Gross Derivative Assets
 
Gross Derivative Liabilities
(Dollars in billions)
Contract/
Notional (1)
 
Trading
Derivatives
and
Economic
Hedges
 
Qualifying
Accounting
Hedges
 
Total
 
Trading
Derivatives
and
Economic
Hedges
 
Qualifying
Accounting
Hedges
 
Total
Interest rate contracts
 
 
 
 
 
 
 
 
 
 
 
 
 
Swaps
$
35,256.0

 
$
1,147.8

 
$
14.7

 
$
1,162.5

 
$
1,132.8

 
$
5.1

 
$
1,137.9

Futures and forwards
13,171.6

 
3.9

 
—

 
3.9

 
3.9

 
—

 
3.9

Written options
2,348.0

 
—

 
—

 
—

 
111.0

 
—

 
111.0

Purchased options
2,256.2

 
111.3

 
—

 
111.3

 
—

 
—

 
—

Foreign exchange contracts
 
 
 
 
 
 
 
 
 
 
 
 
 
Swaps
2,530.7

 
52.3

 
2.1

 
54.4

 
61.0

 
2.2

 
63.2

Spot, futures and forwards
3,066.8

 
26.2

 
0.3

 
26.5

 
27.5

 
1.2

 
28.7

Written options
446.0

 
—

 
—

 
—

 
6.9

 
—

 
6.9

Purchased options
373.7

 
6.6

 
—

 
6.6

 
—

 
—

 
—

Equity contracts
 
 
 
 
 
 
 
 
 
 
 
 
 
Swaps
120.8

 
2.0

 
—

 
2.0

 
2.3

 
—

 
2.3

Futures and forwards
52.8

 
1.5

 
—

 
1.5

 
1.4

 
—

 
1.4

Written options
367.0

 
—

 
—

 
—

 
20.7

 
—

 
20.7

Purchased options
334.4

 
20.0

 
—

 
20.0

 
—

 
—

 
—

Commodity contracts
 
 
 
 
 
 
 
 
 
 
 
 
 
Swaps
69.2

 
3.3

 
—

 
3.3

 
4.6

 
—

 
4.6

Futures and forwards
581.6

 
4.9

 
—

 
4.9

 
2.7

 
—

 
2.7

Written options
195.0

 
—

 
—

 
—

 
3.1

 
—

 
3.1

Purchased options
197.8

 
2.6

 
—

 
2.6

 
—

 
—

 
—

Credit derivatives
 
 
 
 
 
 
 
 
 
 
 
 
 
Purchased credit derivatives:
 
 
 
 
 
 
 
 
 
 
 
 
 
Credit default swaps
1,654.5

 
45.1

 
—

 
45.1

 
19.8

 
—

 
19.8

Total return swaps/other
36.6

 
2.4

 
—

 
2.4

 
2.9

 
—

 
2.9

Written credit derivatives:
 
 
 
 
 
 
 
 
 
 
 
 
 
Credit default swaps
1,612.3

 
21.1

 
—

 
21.1

 
41.6

 
—

 
41.6

Total return swaps/other
60.2

 
1.6

 
—

 
1.6

 
0.5

 
—

 
0.5

Gross derivative assets/liabilities
 
 
$
1,452.6

 
$
17.1

 
$
1,469.7

 
$
1,442.7

 
$
8.5

 
$
1,451.2

Less: Legally enforceable master netting agreements
 
 
 
 
 
(1,351.7
)
 
 
 
 
 
(1,351.7
)
Less: Cash collateral received/paid
 
 
 
 
 
 
(60.0
)
 
 
 
 
 
(48.1
)
Total derivative assets/liabilities
 
 
 
 
 
 
$
57.9

 
 
 
 
 
$
51.4

(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
Economic
Hedges
 
Qualifying
Accounting
Hedges
 
Total
 
Trading
Derivatives
and
Economic
Hedges
 
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 asset and liability management (ALM) and risk management activities include the use of derivatives to mitigate risk to the Corporation including derivatives designated as qualifying accounting hedges and economic hedges. 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 hedge 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 as economic hedges of the fair value of mortgage servicing rights (MSRs). For additional information on MSRs, see Note 18 – 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 accounted for as economic hedges and changes in fair value are 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, exchange rates and commodity prices (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, 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 the three and nine months ended September 30, 2012 and 2011.

Derivatives Designated as Fair Value Hedges
Gains (losses)
Three Months Ended September 30
 
Nine Months Ended September 30
 
2012
 
2012
(Dollars in millions)
Derivative
 
Hedged
Item
 
Hedge
Ineffectiveness
 
Derivative
 
Hedged
Item
 
Hedge
Ineffectiveness
Interest rate risk on long-term debt (1)
$
109

 
$
(385
)
 
$
(276
)
 
$
518

 
$
(1,265
)
 
$
(747
)
Interest rate and foreign currency risk on long-term debt (1)
(716
)
 
647

 
(69
)
 
(1,455
)
 
1,259

 
(196
)
Interest rate risk on AFS securities (2)
349

 
(309
)
 
40

 
(593
)
 
659

 
66

Commodity price risk on commodity inventory (3)
(24
)
 
24

 
—

 
(10
)
 
10

 
—

Total
$
(282
)
 
$
(23
)
 
$
(305
)
 
$
(1,540
)
 
$
663

 
$
(877
)
 
 
 
 
 
 
 
 
 
 
 
 
 
2011
 
2011
Interest rate risk on long-term debt (1)
$
4,055

 
$
(4,233
)
 
$
(178
)
 
$
4,494

 
$
(4,938
)
 
$
(444
)
Interest rate and foreign currency risk on long-term debt (1)
(871
)
 
759

 
(112
)
 
1,317

 
(1,534
)
 
(217
)
Interest rate risk on AFS securities (2)
(10,420
)
 
9,810

 
(610
)
 
(11,141
)
 
10,356

 
(785
)
Commodity price risk on commodity inventory (3)
16

 
(16
)
 
—

 
32

 
(32
)
 
—

Total
$
(7,220
)
 
$
6,320

 
$
(900
)
 
$
(5,298
)
 
$
3,852

 
$
(1,446
)
(1) 
Amounts are recorded in interest expense on long-term debt and in other income (loss).
(2) 
Amounts are recorded in interest income on AFS 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 the three and nine months ended September 30, 2012 and 2011. During the next 12 months, net losses in accumulated other comprehensive income (OCI) of approximately $1.2 billion ($750 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 losses of $7 million related to long-term debt designated as a net investment hedge for the nine months ended September 30, 2012 compared to gains of $145 million and losses of $33 million for the three and nine months ended September 30, 2011. There were no gains or losses related to these hedges for the three months ended September 30, 2012.

Derivatives Designated as Cash Flow and Net Investment Hedges
 
Three Months Ended September 30
 
Nine Months Ended September 30
 
2012
 
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)
 
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
$
21

 
$
(260
)
 
$
—

 
$
(32
)
 
$
(636
)
 
$
—

Commodity price risk on forecasted purchases and sales
—

 
3

 
—

 
—

 
—

 
—

Price risk on restricted stock awards
65

 
(28
)
 
—

 
156

 
(89
)
 
—

Total
$
86

 
$
(285
)
 
$
—

 
$
124

 
$
(725
)
 
$
—

Net investment hedges
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange risk
$
(1,149
)
 
$
11

 
$
(13
)
 
$
(1,021
)
 
$
(26
)
 
$
(180
)
 
 
 
 
 
 
 
 
 
 
 
 
 
2011
 
2011
Cash flow hedges
 
 
 
 
 
 
 
 
 
 
 
Interest rate risk on variable rate portfolios
$
(1,550
)
 
$
(464
)
 
$
26

 
$
(2,272
)
 
$
(1,212
)
 
$
(8
)
Commodity price risk on forecasted purchases and sales
5

 
2

 
2

 
(4
)
 
5

 
—

Price risk on restricted stock awards
(204
)
 
(75
)
 
—

 
(395
)
 
(145
)
 
—

Total
$
(1,749
)
 
$
(537
)
 
$
28

 
$
(2,671
)
 
$
(1,352
)
 
$
(8
)
Net investment hedges
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange risk
$
2,212

 
$
(16
)
 
$
(175
)
 
$
597

 
$
407

 
$
(425
)
(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 restricted stock units (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 to the Corporation driven by fluctuations in the share price of the Corporation’s 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 accounted for as economic hedges and changes in fair value are recorded in personnel expense. For more information on RSUs and related hedges, see Note 14 – Pension, Postretirement and Certain Compensation Plans.
Derivatives Accounted for as Economic Hedges

Derivatives accounted for as economic hedges, because either they did not qualify for or were not designated as accounting hedges, are used by the Corporation to reduce certain risk exposures. The table below presents gains (losses) on these derivatives for the three and nine months ended September 30, 2012 and 2011. These gains (losses) are largely offset by the income or expense that is recorded on the economically hedged item.

Derivatives Accounted for as Economic Hedges
Gains (losses)
Three Months Ended September 30
 
Nine Months Ended September 30
(Dollars in millions)
2012
 
2011
 
2012
 
2011
Price risk on mortgage banking production income (1, 2)
$
850

 
$
1,158

 
$
2,240

 
$
2,324

Market-related risk on mortgage banking servicing income (1)
822

 
2,678

 
1,970

 
3,063

Credit risk on loans (3)
(32
)
 
66

 
(71
)
 
38

Interest rate and foreign currency risk on long-term debt and other foreign exchange transactions (4)
(309
)
 
(3,616
)
 
(987
)
 
1,604

Price risk on restricted stock awards (5)
142

 
(392
)
 
392

 
(556
)
Other
16

 
104

 
105

 
172

Total
$
1,489

 
$
(2
)
 
$
3,649

 
$
6,645

(1) 
Net gains on these derivatives are recorded in mortgage banking income.
(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 $1.0 billion and $2.4 billion for the three and nine months ended September 30, 2012 compared to $1.2 billion and $3.4 billion for the same periods in 2011.
(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 economic hedges of 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) in the Corporation's Consolidated Statement of Income. 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 the three and nine months ended September 30, 2012 and 2011. 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.

Sales and Trading Revenue
 
Three Months Ended September 30
 
Nine Months Ended September 30
 
2012
 
2012
(Dollars in millions)
Trading
Account
Profits
 
Net Interest Income
 
Other (1)
 
Total
 
Trading
Account
Profits
 
Net Interest Income
 
Other (1)
 
Total
Interest rate risk
$
67

 
$
267

 
$
7

 
$
341

 
$
522

 
$
752

 
$
28

 
$
1,302

Foreign exchange risk
192

 
1

 
2

 
195

 
658

 
5

 
(35
)
 
628

Equity risk
196

 
15

 
453

 
664

 
989

 
(90
)
 
1,432

 
2,331

Credit risk
661

 
552

 
130

 
1,343

 
2,359

 
1,632

 
862

 
4,853

Other risk
120

 
(45
)
 
(12
)
 
63

 
453

 
(169
)
 
30

 
314

Total sales and trading revenue
$
1,236

 
$
790

 
$
580

 
$
2,606

 
$
4,981

 
$
2,130

 
$
2,317

 
$
9,428

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2011
 
2011
Interest rate risk
$
1,237

 
$
256

 
$
24

 
$
1,517

 
$
2,029

 
$
672

 
$
21

 
$
2,722

Foreign exchange risk
332

 
2

 
(16
)
 
318

 
825

 
8

 
(48
)
 
785

Equity risk
280

 
48

 
628

 
956

 
1,341

 
77

 
1,854

 
3,272

Credit risk
(630
)
 
636

 
41

 
47

 
1,365

 
2,044

 
683

 
4,092

Other risk
201

 
(62
)
 
(8
)
 
131

 
488

 
(126
)
 
(16
)
 
346

Total sales and trading revenue
$
1,420

 
$
880

 
$
669

 
$
2,969

 
$
6,048

 
$
2,675

 
$
2,494

 
$
11,217

(1) 
Represents amounts in the investment and brokerage services and other income (loss) line items in the Consolidated Statement of Income that are recorded in Global Markets and included in the definition of sales and trading revenue. Includes investment and brokerage services revenue of $425 million and $1.4 billion for the three and nine months ended September 30, 2012 and $584 million and $1.8 billion for the same periods in 2011.

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 September 30, 2012 and December 31, 2011 in the table below. These instruments are classified as investment and non-investment grade based on the credit quality of the underlying reference obligation. The Corporation considers ratings of BBB- or higher as investment grade. Non-investment grade includes non-rated credit derivative instruments.

Credit Derivative Instruments
 
 
 
September 30, 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
$
53

 
$
1,423

 
$
8,197

 
$
4,000

 
$
13,673

Non-investment grade
1,028

 
4,859

 
8,067

 
13,935

 
27,889

Total
1,081

 
6,282

 
16,264

 
17,935

 
41,562

Total return swaps/other:
 
 
 
 
 
 
 
 
 
Investment grade
42

 
—

 
—

 
—

 
42

Non-investment grade
159

 
71

 
230

 
18

 
478

Total
201

 
71

 
230

 
18

 
520

Total credit derivatives
$
1,282

 
$
6,353

 
$
16,494

 
$
17,953

 
$
42,082

Credit-related notes: (1)
 
 
 
 
 
 
 
 
 
Investment grade
$
4

 
$
31

 
$
324

 
$
3,638

 
$
3,997

Non-investment grade
161

 
132

 
144

 
1,745

 
2,182

Total credit-related notes
$
165

 
$
163

 
$
468

 
$
5,383

 
$
6,179

 
Maximum Payout/Notional
Credit default swaps:
 
 
 
 
 
 
 
 
 
Investment grade
$
252,973

 
$
387,360

 
$
449,827

 
$
135,761

 
$
1,225,921

Non-investment grade
88,386

 
115,839

 
123,365

 
58,752

 
386,342

Total
341,359

 
503,199

 
573,192

 
194,513

 
1,612,263

Total return swaps/other:
 
 
 
 
 
 
 
 
 
Investment grade
16,994

 
15

 
—

 
—

 
17,009

Non-investment grade
29,704

 
7,575

 
5,557

 
338

 
43,174

Total
46,698

 
7,590

 
5,557

 
338

 
60,183

Total credit derivatives
$
388,057

 
$
510,789

 
$
578,749

 
$
194,851

 
$
1,672,446

 
 
 
 
 
 
 
 
 
 
 
December 31, 2011
 
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 economically hedges 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 September 30, 2012 was $26.5 billion and $1.2 trillion compared to $48.0 billion and $1.0 trillion at December 31, 2011.

Credit-related notes in the table on page 169 include investments in securities issued by collateralized debt obligation (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 over-the-counter (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 162, 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 September 30, 2012 and December 31, 2011, the Corporation held cash and securities collateral of $86.3 billion and $87.7 billion, and posted cash and securities collateral of $78.1 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. The following discussion presents information as a result of the downgrade by Moody's Investors Service, Inc. on June 21, 2012.

At September 30, 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 $2.4 billion, comprised of $741 million for BANA and $1.7 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 September 30, 2012, the current liability recorded for these derivative contracts was $2.1 billion, against which the Corporation and certain subsidiaries had posted approximately $2.0 billion of collateral.

At September 30, 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 $2.9 billion comprised of $2.3 billion for BANA and $538 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 $4.3 billion in additional incremental collateral comprised of $331 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 September 30, 2012 was $4.5 billion, against which $3.8 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 September 30, 2012 was an incremental $1.9 billion, against which $1.2 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. 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 arrangements 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 credit valuation adjustment (CVA). Independently, counterparty credit spreads may tighten, which would result in an offsetting decrease to CVA.

The Corporation may enter into economic hedges 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 the three months ended September 30, 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. This change in estimate increased CVA by $175 million and DVA by $171 million resulting in a net negative earnings impact of $4 million for the three and nine months ended September 30, 2012. The effect of this change in estimate is reflected in the table below.

The Valuation Adjustments on Derivatives table presents CVA gains (losses) 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
 
Three Months Ended September 30
 
Nine Months Ended September 30
 
2012
 
2011
 
2012
 
2011
(Dollars in millions)
Gross
Net
 
Gross
Net
 
Gross
Net
 
Gross
Net
Derivative assets (CVA) (1)
$
525

$
75

 
$
(1,570
)
$
(81
)
 
$
725

$
237

 
$
(2,014
)
$
(698
)
Derivative liabilities (DVA) (2)
(606
)
(583
)
 
1,767

1,710

 
(1,899
)
(2,200
)
 
1,664

1,474

(1) 
At September 30, 2012 and December 31, 2011, the cumulative CVA reduced the derivative assets balance by $2.7 billion and $2.8 billion.
(2) 
At September 30, 2012 and December 31, 2011, the Corporation’s cumulative DVA reduced the derivative liabilities balance by $1.1 billion and $2.4 billion.