Quarterly report pursuant to Section 13 or 15(d)

Derivatives

v2.4.0.6
Derivatives
 9 Months Ended
Sep. 30, 2012
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivatives
Note 6.
Derivatives

A derivative is an instrument whose value is derived from an underlying instrument or index, such as interest rates, equity security prices, currencies, commodity prices or credit spreads. Derivatives include futures, forwards, swaps, option contracts, and other financial instruments with similar characteristics. Derivative contracts often involve future commitments to exchange interest payment streams or currencies based on a notional or contractual amount (e.g., interest rate swaps or currency forwards) or to purchase or sell other financial instruments at specified terms on a specified date (e.g., options to buy or sell securities or currencies).

Derivatives Accounting establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (“embedded derivatives”) and for hedging activities. Derivatives Accounting requires that an entity recognize all derivatives as either assets or liabilities and measure those instruments at fair value. The fair value of all derivatives and associated cash collateral is recorded on a net-by-counterparty basis on the Condensed Consolidated Balance Sheets where Merrill Lynch believes a legal right of offset exists under an enforceable netting agreement. All derivatives, including bifurcated embedded derivatives within structured notes, are reported on the Condensed Consolidated Balance Sheets as trading assets and liabilities.

The accounting for changes in fair value of a derivative instrument depends on its intended use and if it is designated and qualifies as an accounting hedging instrument under Derivatives Accounting.

Trading derivatives

Merrill Lynch enters into derivatives to facilitate client transactions, for trading and financing purposes, and to manage risk exposures arising from trading assets and liabilities. Changes in fair value for these derivatives are reported in current period earnings as principal transactions revenues.

Derivatives that contain a significant financing element

Merrill Lynch may enter into certain transactions that are documented as derivatives where a significant cash investment is made by one party. Certain derivative instruments that contain a significant financing element at inception and where Merrill Lynch is deemed to be the borrower are included in financing activities in the Condensed Consolidated Statements of Cash Flows. The cash flows from all other derivative transactions that do not contain a significant financing element at inception are included in operating activities.

Non-trading derivatives

Merrill Lynch also enters into derivatives in order to manage risk exposures arising from assets and liabilities not carried at fair value as follows:

1.
Merrill Lynch's debt was issued in a variety of maturities and currencies to achieve the lowest cost financing possible. Merrill Lynch enters into derivative transactions to hedge these liabilities. Derivatives used most frequently include swap agreements that:

•
Convert fixed-rate interest payments into variable-rate interest payments;

•
Change the underlying interest rate basis or reset frequency; and

•
Change the settlement currency of a debt instrument.

Changes in the fair value of these interest rate and foreign currency derivatives are reported in interest expense or other revenues.

2.
Merrill Lynch uses foreign-exchange forward contracts, foreign-exchange options, and currency swaps to hedge its net investments in foreign operations, as well as other foreign currency exposures (e.g., non-U.S. dollar denominated debt and expenses). These instruments are used to mitigate the impact of changes in exchange rates. Changes in the fair value of these instruments are reported in OCI and other revenues when net investment hedge accounting is applied; otherwise changes in fair value are reported in other revenues.

3.
Merrill Lynch enters into futures, swaps, options and forward contracts to manage the price risk of certain commodity inventory and forecasted commodity purchases and sales. Changes in fair value of these derivatives are reported in principal transactions revenues, unless cash flow hedge accounting is applied.

4.
Merrill Lynch enters into CDS to manage the credit risk on certain loans that are not part of trading activities. Changes in the fair value of these derivatives are reported in other revenues.

Certain derivatives, primarily entered into with an affiliate, qualify as accounting hedges under Derivatives Accounting. These derivatives are designated as one of the following:

1.  A hedge of the fair value of a recognized asset or liability (“fair value hedge”). Changes in the fair value of derivatives that are designated and qualify as fair value hedges of interest rate risk, foreign exchange risk and commodity price risk, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings as interest expense, other revenues, or principal transactions.

2.  A hedge of the variability of cash flows to be received or paid related to a recognized asset, liability or forecasted transaction (“cash flow hedge”). Changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recorded in OCI until earnings are affected by the variability of cash flows of the hedged asset or liability or when the forecasted purchase or sale occurs. All cash flow hedges were de-designated in 2011. See Note 6 to the Consolidated Financial Statements in the 2011 Annual Report for further information. The amount remaining in OCI that is expected to be reclassified into earnings in the next 12 months is not material.

3.  A hedge of a net investment in a foreign operation (“net investment hedge”). Changes in the fair value of derivatives that are designated and qualify as hedges of a net investment in a foreign operation are recorded in the foreign currency translation adjustment account within OCI. Changes in the fair value of the hedging instruments that are associated with the difference between the spot rate and the contracted forward rate are recorded in current period earnings in other revenues.

Merrill Lynch formally assesses, both at the inception of the hedge and on an ongoing basis, whether the hedging derivatives are highly effective in offsetting changes in fair value or cash flows of hedged items. Merrill Lynch uses regression analysis at the hedge's inception and for each reporting period thereafter to assess whether the derivative used in its hedging transaction is expected to be and has been highly effective in offsetting changes in the fair value or cash flows of the hedged item. When it is determined that a derivative is not highly effective as a hedge, Merrill Lynch discontinues hedge accounting.


Hedge accounting activity for 2012 and 2011 included the following:
Fair value hedges

(dollars in millions)
 
 
 
 
 
 
 
 
2012
 
2011
 
Derivative (1)
Hedged Item (1)(2)
Hedge Ineffectiveness (1)
 
Derivative (1)
Hedged Item (1)(2)
Hedge Ineffectiveness (1)
For the three months ended September 30:
 
 
 
 
 
 
 
Interest rate risk on USD denominated long-term borrowings
$
(49
)
$
(125
)
$
(174
)
 
$
1,555

$
(1,744
)
$
(189
)
Interest rate risk on foreign currency denominated long-term borrowings
(207
)
153

(54
)
 
(345
)
287

(58
)
Commodity price risk on commodity inventory
(24
)
24

—

 
16

(16
)
—

 
 
 
 
 
 
 
 
For the nine months ended September 30:
 
 
 
 
 
 
 
Interest rate risk on USD denominated long-term borrowings
11

(496
)
(485
)
 
1,700

(2,100
)
(400
)
Interest rate risk on foreign currency denominated long-term borrowings
(531
)
383

(148
)
 
335

(499
)
(164
)
Commodity price risk on commodity inventory
(10
)
10

—

 
—

—

—

 
 
 
 
 
 
 
 
 
2012
 
 
2011
 
 
 Trading Assets
 Trading Liabilities
 
 
 Trading Assets
 Trading Liabilities
 
 
 
 
 
 
 
 
 
As of September 30, 2012 and December 31, 2011:
 
 
 
 
 
 
 
Carrying value of hedging derivatives:
 
 
 
 
 
 
 
Long-term borrowings
$
6,177

$
887

 
 
$
6,940

$
841

 
Commodity inventory
28

2

 
 
70

5

 
Notional amount of hedging derivatives:
 
 
 
 
 
 
 
Long-term borrowings
37,019

9,813

 
 
44,180

11,092

 
Commodity inventory
115

6

 
 
152

6

 
(1)
Amounts are recorded in interest expense and other revenues for long-term borrowings and principal transactions for commodity inventory.
(2)
Excludes the impact of the accretion of purchase accounting adjustments made to certain long-term borrowings in connection with the acquisition of Merrill Lynch by Bank of America.

Net investment hedges of foreign operations
(dollars in millions)
 
 
 
 
 
 
 
 
 
2012
 
 
 
2011
 
 
Gains (losses) Recognized in Accumulated OCI
Gains (losses) in Income Reclassified from Accumulated OCI (1)
Hedge Ineffectiveness and Amounts Excluded from Effectiveness Testing (1)
 
Gains (losses) Recognized in Accumulated OCI
Gains (losses) in Income Reclassified from Accumulated OCI (1)
Hedge Ineffectiveness and Amounts Excluded from Effectiveness Testing (1)
For the three months ended September 30:
 
 

 
 
 
 

 
Foreign exchange risk
$
(567
)
$
(12
)
$
12

 
$
1,215

$
(18
)
$
(110
)
 
 
 
 
 
 
 
 
For the nine months ended September 30:
 
 
 
 
 
 
 
Foreign exchange risk
(457
)
(49
)
(86
)
 
254

(21
)
(267
)
 
 
 
 
 
 
 
 
 
 
2012
 
 
 
2011
 
As of September 30, 2012 and December 31, 2011:
 
 
 
 
 
 
 
Carrying value of hedging derivatives:
 
 
 
 
 
 
 
   Trading assets
 
$
175

 
 
 
$
690

 
   Trading liabilities
 
794

 
 
 
492

 
Carrying value of non-derivative hedges:
 
 
 
 
 
 
 
   Long-term borrowings
 
—

 
 
 
61

 
Notional amount of hedging derivatives:
 
 
 
 
 
 
 
   in an asset position
 
3,328

 
 
 
20,068

 
   in a liability position
 
19,560

 
 
 
7,338

 
 
 
 
 
 
 
 
 
(1)
Amounts are recorded in other revenues.
Net gains (losses) on economic hedges
(dollars in millions)
 
 
 
 
 
 
2012(1)
 
2011(1)
For the three months ended September 30:
 
 
 
 
Interest rate risk
 
$
6

 
$
182

Foreign currency risk
 
48

 
(2,350
)
Credit risk
 
(22
)
 
65

 
 
 
 
 
For the nine months ended September 30:
 
 
 
 
Interest rate risk
 
17

 
178

Foreign currency risk
 
(456
)
 
796

Credit risk
 
(53
)
 
48

(1)
Amounts are recorded in other revenues and interest expense.

The amounts in the “Net gains (losses) on economic hedges” table above represent net gains (losses) on derivatives that are not used for trading purposes and are not used in accounting hedging relationships. Interest rate risk primarily relates to derivatives used to economically hedge long-term borrowings. Foreign currency risk primarily relates to economic hedges of foreign currency denominated transactions that generate earnings upon remeasurement in accordance with ASC 830-20, Foreign Currency Transactions (“Foreign Currency Transactions”). As both the remeasurement of the foreign currency risk on the transaction and the changes in fair value of the derivative are recorded in earnings, hedge accounting is not applied. Credit risk relates to credit default swaps used to economically manage the credit risk on certain loans not included in trading activities.


Derivative balances by primary risk

Derivative instruments contain numerous market risks. In particular, most derivatives have interest rate risk, as they contain an element of financing risk that is affected by changes in interest rates. Additionally, derivatives expose Merrill Lynch to counterparty credit risk, although this is generally mitigated by collateral margining and netting arrangements. For disclosure purposes below, the primary risk of a derivative is largely determined by the business that is engaging in the derivative activity. For instance, a derivative that is initiated by an equities derivative business will generally have equity price risk as its primary underlying market risk and is classified as such for the purposes of this disclosure, despite the fact that there may be other market risks that affect the value of the instrument.

The following tables identify the primary risk for derivative instruments, which includes trading, non-trading and bifurcated embedded derivatives, at September 30, 2012 and December 31, 2011. The primary risk is provided on a gross basis, prior to the application of the impact of counterparty and cash collateral netting.

(dollars in millions)
 
As of September 30, 2012
 
Contract/
Notional
 
Trading Assets-
Derivative Contracts
 
Contract/
Notional
 
Trading Liabilities-
Derivative Contracts
Interest rate contracts
 

 
 

 
 

 
 

Swaps
$
8,374,191

 
$
536,237

 
$
8,113,852

 
$
532,035

Futures and forwards
2,378,341

 
2,325

 
2,380,931

 
2,053

Written options
—

 
—

 
1,279,262

 
64,754

Purchased options
1,272,147

 
68,817

 
—

 
—

Foreign exchange contracts
 
 
 
 
 
 
 
Swaps
787,495

 
32,344

 
807,193

 
38,830

Spot, futures and forwards
93,990

 
2,259

 
88,490

 
2,359

Written options
—

 
—

 
274,860

 
5,289

Purchased options
213,044

 
4,932

 
—

 
—

Equity contracts
 
 
 
 
 
 
 
Swaps
27,768

 
1,266

 
24,397

 
1,399

Futures and forwards
27,468

 
1,464

 
24,307

 
1,423

Written options
—

 
—

 
327,939

 
15,777

Purchased options
314,432

 
14,405

 
—

 
—

Commodity contracts
 
 
 
 
 
 
 
Swaps
32,484

 
3,188

 
33,159

 
4,581

Futures and forwards
299,124

 
4,881

 
282,453

 
2,696

Written options
—

 
—

 
191,816

 
3,001

Purchased options
194,053

 
2,450

 
—

 
—

Credit derivatives
 

 
 

 
 

 
 

Purchased protection:
 

 
 

 
 

 
 

Credit default swaps
120,185

 
11,510

 
101,695

 
2,065

Total return swaps
5,812

 
619

 
3,508

 
1,175

Other credit derivatives
1,705

 
3

 
242

 
—

Written protection:
 

 
 

 
 
 
 
Credit default swaps
103,658

 
2,766

 
115,520

 
10,428

Total return swaps
1,556

 
340

 
14,361

 
452

Other credit derivatives
—

 
1

 
1,279

 
4

Gross derivative assets/liabilities
$
14,247,453

 
$
689,807

 
$
14,065,264

 
$
688,321

Less: Legally enforceable master netting
 
 
(633,047
)
 
 
 
(633,047
)
Less: Cash collateral received/paid
 

 
(30,139
)
 
 

 
(32,703
)
Total derivative assets and liabilities
 

 
$
26,621

 
 

 
$
22,571

 
 
 
 
 
 
 
 
 
(dollars in millions)
 
As of December 31, 2011
 
Contract/
Notional
 
Trading Assets-
Derivative Contracts
 
Contract/
Notional
 
Trading Liabilities-
Derivative Contracts
Interest rate contracts
 

 
 

 
 

 
 

Swaps
$
8,196,809

 
$
564,696

 
$
7,978,404

 
$
560,638

Futures and forwards
2,117,971

 
1,510

 
2,003,741

 
1,339

Written options
—

 
—

 
1,419,278

 
66,733

Purchased options
1,336,149

 
69,812

 
—

 
—

Foreign exchange contracts
 

 
 

 
 

 
 

Swaps
766,899

 
27,312

 
798,173

 
35,299

Spot, futures and forwards
104,356

 
3,887

 
98,411

 
3,791

Written options
—

 
—

 
249,575

 
7,437

Purchased options
236,465

 
7,220

 
—

 
—

Equity contracts
 

 
 

 
 

 
 

Swaps
23,233

 
1,028

 
22,887

 
1,141

Futures and forwards
30,791

 
1,747

 
20,988

 
1,450

Written options
—

 
—

 
345,947

 
14,596

Purchased options
341,731

 
14,816

 
—

 
—

Commodity contracts
 

 
 

 
 

 
 

Swaps
35,681

 
4,823

 
36,391

 
5,799

Futures and forwards
233,567

 
5,254

 
236,919

 
3,183

Written options
—

 
—

 
140,600

 
9,443

Purchased options
139,312

 
9,426

 
—

 
—

Credit derivatives
 

 
 

 
 

 
 

Purchased protection:
 

 
 

 
 

 
 

Credit default swaps
174,857

 
20,124

 
67,664

 
1,416

Total return swaps
2,771

 
407

 
3,493

 
291

Other credit derivatives
274

 
3

 
25

 
—

Written protection:
 

 
 

 
 

 
 
Credit default swaps
66,841

 
1,737

 
179,907

 
19,061

Total return swaps
4,350

 
226

 
1,239

 
129

Other credit derivatives
—

 
—

 
25

 
1

Gross derivative assets/liabilities
$
13,812,057

 
$
734,028

 
$
13,603,667

 
$
731,747

Less: Legally enforceable master netting
 

 
(672,524
)
 
 

 
(672,524
)
Less: Cash collateral received/paid
 

 
(26,491
)
 
 

 
(32,984
)
Total derivative assets and liabilities
 

 
$
35,013

 
 

 
$
26,239

 
 
 
 
 
 
 
 

Trading revenues

Merrill Lynch enters into trading derivatives and non-derivative cash instruments to facilitate client transactions, for trading and financing purposes, and to manage risk exposures arising from trading assets and liabilities. The resulting risk from derivatives and non-derivative cash instruments is managed on a portfolio basis as part of Merrill Lynch's sales and trading activities and the related revenue is recorded on different income statement line items, including principal transactions, commissions, other revenues and net interest (expense) income.

Sales and trading revenue includes changes in fair value and realized gains and losses on the sales of trading and other assets, which are included in principal transactions and other revenues, net interest (expense) income, and commissions. Initial trading related 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. That revenue is included within principal transactions on the Condensed Consolidated Statements of (Loss) Earnings. For equity securities, commissions related to purchases and sales are recorded in commissions on the Condensed Consolidated Statements of (Loss) Earnings. Changes in the fair value of these equity securities are included in principal transactions. These amounts are reflected in equity risk in the tables below. Revenue for debt securities, with the exception of interest, is typically included in principal transactions. Unlike commissions for equity securities, the initial revenue related to broker/dealer services for debt securities is included in the pricing of the instrument rather than charged through separate fee agreements. Therefore, this revenue is recorded in principal transactions as part of the initial mark to fair value. In transactions where Merrill Lynch acts as an agent, fees are earned and recorded in commissions. In the tables below, most government debt securities are reflected in interest rate risk. All other government debt securities (including, for example, municipal bonds and emerging markets government debt) and corporate debt securities are included in credit risk.

For derivatives, revenue is typically included in principal transactions. Similar to debt securities, the initial revenue related to dealer services is included in the initial pricing of the instrument rather than charged through separate fee agreements. Therefore, this revenue is recorded in principal transactions as part of the initial mark to fair value. In transactions where Merrill Lynch acts as agent, which includes exchange traded futures and options, fees are earned and recorded in commissions. Derivatives are included in the tables below based on their predominant risk (e.g., credit default swaps are included in credit risk).

Certain instruments, primarily available-for-sale securities and loans, are not considered trading assets or liabilities. Gains/losses on sales and changes in fair value of these instruments, where applicable (e.g., the fair value option has been elected), are recorded in other revenues. These instruments are typically reflected in credit risk.

Interest revenue for debt securities and loans is included in net interest (expense) income.

The following tables identify the amounts in the income statement line items attributable to trading and non-trading activities, including both derivatives and non-derivative cash instruments categorized by primary risk for the three and nine months ended September 30, 2012 and September 30, 2011.

Non-trading related amounts include activities in connection with principal investment, wealth management, and certain lending activities; economic hedging activity discussed in the Non-trading derivatives section above; and the impact of changes in Merrill Lynch's own creditworthiness on borrowings accounted for at fair value.
For The Three Months Ended September 30, 2012
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues(1)
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
246

 
$
18

 
$
3

 
$
171

 
$
438

Foreign exchange risk
(5
)
 
—

 
1

 
—

 
(4
)
Equity risk
173

 
594

 
14

 
96

 
877

Commodity risk
132

 
—

 
(1
)
 
(29
)
 
102

Credit risk
515

 
—

 
77

 
477

 
1,069

Total trading related
1,061

 
612

 
94

 
715

 
2,482

Non-trading related
(868
)
 
597

 
149

 
(753
)
 
(875
)
Total
$
193

 
$
1,209

 
$
243

 
$
(38
)
 
$
1,607

 
 
 
 
 
 
 
 
 
 
(1) Includes other income and other-than-temporary impairment losses on available-for-sale debt securities.





For The Nine Months Ended September 30, 2012
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues(1)
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
624

 
$
55

 
$
7

 
$
543

 
$
1,229

Foreign exchange risk
55

 
—

 
1

 
—

 
56

Equity risk
1,949

 
1,926

 
56

 
(873
)
 
3,058

Commodity risk
487

 
—

 
—

 
(87
)
 
400

Credit risk
1,914

 
—

 
143

 
1,554

 
3,611

Total trading related
5,029

 
1,981

 
207

 
1,137

 
8,354

Non-trading related
(3,040
)
 
1,823

 
1,058

 
(2,253
)
 
(2,412
)
Total
$
1,989

 
$
3,804

 
$
1,265

 
$
(1,116
)
 
$
5,942

 
 
 
 
 
 
 
 
 
 
(1)
Includes other income and other-than-temporary impairment losses on available-for-sale debt securities.

For The Three Months Ended September 30, 2011
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues(1)
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
396

 
$
21

 
$
—

 
$
205

 
$
622

Foreign exchange risk
24

 
—

 
—

 
1

 
25

Equity risk
132

 
792

 
36

 
104

 
1,064

Commodity risk
216

 
—

 
1

 
(29
)
 
188

Credit risk
(829
)
 
16

 
33

 
634

 
(146
)
Total trading related
(61
)
 
829

 
70

 
915

 
1,753

Non-trading related
2,842

 
612

 
(1,127
)
 
(803
)
 
1,524

Total
$
2,781

 
$
1,441

 
$
(1,057
)
 
$
112

 
$
3,277

 
 
 
 
 
 
 
 
 
 
(1)
Includes other income and other-than-temporary impairment losses on available-for-sale debt securities.

For The Nine Months Ended September 30, 2011
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues(1)
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
746

 
$
64

 
$
19

 
$
585

 
$
1,414

Foreign exchange risk
72

 
—

 
—

 
6

 
78

Equity risk
2,020

 
2,458

 
94

 
(715
)
 
3,857

Commodity risk
523

 
—

 
—

 
(86
)
 
437

Credit risk
62

 
44

 
390

 
2,028

 
2,524

Total trading related
3,423

 
2,566

 
503

 
1,818

 
8,310

Non-trading related
2,702

 
1,912

 
1,230

 
(2,543
)
 
3,301

Total
$
6,125

 
$
4,478

 
$
1,733

 
$
(725
)
 
$
11,611

 
 
 
 
 
 
 
 
 
 
(1)
Includes other income and other-than-temporary impairment losses on available-for-sale debt securities.

Credit Derivatives

Credit derivatives derive value based on an underlying third party referenced obligation or a portfolio of referenced obligations. Merrill Lynch is both a seller and a buyer of credit protection. A seller of credit protection is required to make payments to a buyer upon the occurrence of a predefined credit event. Such credit events generally include bankruptcy of the referenced credit entity and failure to pay under their credit obligations, as well as acceleration of indebtedness and payment repudiation or moratorium. For credit derivatives based on a portfolio of referenced credits or credit indices, Merrill Lynch as a seller of credit protection 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 derivatives where Merrill Lynch is the seller of credit protection are summarized below:
(dollars in millions)
 
Maximum
Payout/
Notional
 
Less than
1 year
 
1 − 3 years
 
3 − 5 years
 
Over 5 years
 
Carrying
Value(1)
At September 30, 2012:
 

 
 

 
 

 
 

 
 

 
 

Derivative contracts:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

Investment grade(2)
$
151,359

 
$
27,011

 
$
50,121

 
$
60,538

 
$
13,689

 
$
2,356

Non-investment grade(2)
85,015

 
11,456

 
20,514

 
29,518

 
23,527

 
8,528

Total credit derivatives
236,374

 
38,467

 
70,635

 
90,056

 
37,216

 
10,884

Credit related notes:
 

 
 

 
 

 
 

 
 

 
 

Investment grade(2)
2,978

 
4

 
6

 
214

 
2,754

 
2,978

Non-investment grade(2)
1,600

 
158

 
90

 
143

 
1,209

 
1,600

Total credit related notes
4,578

 
162

 
96

 
357

 
3,963

 
4,578

Total derivative contracts
$
240,952

 
$
38,629

 
$
70,731

 
$
90,413

 
$
41,179

 
$
15,462

At December 31, 2011:
 

 
 

 
 

 
 

 
 

 
 

Derivative contracts:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

Investment grade(2)
$
130,770

 
$
22,021

 
$
47,593

 
$
46,918

 
$
14,238

 
$
4,189

Non-investment grade(2)
121,592

 
13,263

 
26,428

 
38,301

 
43,600

 
15,002

Total credit derivatives
252,362

 
35,284

 
74,021

 
85,219

 
57,838

 
19,191

Credit related notes:
 
 
 
 
 
 
 
 
 
 
 
Investment grade(2)
2,956

 
—

 
7

 
203

 
2,746

 
2,956

Non-investment grade(2)
1,511

 
127

 
77

 
82

 
1,225

 
1,511

  Total credit related notes
4,467

 
127

 
84

 
285

 
3,971

 
4,467

Total derivative contracts
$
256,829

 
$
35,411

 
$
74,105

 
$
85,504

 
$
61,809

 
$
23,658

 
 
 
 
 
 
 
 
 
 
 
 
(1)
Derivative contracts are shown on a gross basis prior to counterparty or cash collateral netting.
(2)
Refers to the creditworthiness of the underlying reference obligations.

For most credit derivatives, the notional value represents the maximum amount payable by Merrill Lynch as a seller of credit protection. However, Merrill Lynch does not exclusively monitor its exposure to credit derivatives based on notional value. Instead, a risk framework is used to define risk tolerances and establish limits to help to ensure that certain credit risk-related losses occur within acceptable, predefined limits. Merrill Lynch discloses internal categorizations (i.e., investment grade, non-investment grade) consistent with how risk is managed to evaluate the payment status of its freestanding credit derivative instruments.

Merrill Lynch economically hedges its exposure to credit derivatives by entering into a variety of offsetting derivative contracts and security positions. For example, in certain instances, Merrill Lynch purchases credit protection with identical underlying referenced names to offset its exposure. At September 30, 2012 and December 31, 2011, the notional value and carrying value of credit protection purchased and credit protection sold by Merrill Lynch with identical underlying referenced names was:

(dollars in millions)
 
Maximum
Payout/
Notional
 
Less than
1 year
 
1 − 3 years
 
3 − 5 years
 
Over 5 years
 
Carrying
Value(1)
At September 30, 2012:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives purchased
$
135,788

 
$
26,208

 
$
44,829

 
$
44,914

 
$
19,837

 
$
4,431

Credit derivatives sold
144,488

 
28,110

 
43,678

 
47,088

 
25,612

 
6,186

At December 31, 2011:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives purchased
219,358

 
31,335

 
63,284

 
77,485

 
47,254

 
15,563

Credit derivatives sold
219,669

 
33,852

 
61,797

 
77,527

 
46,493

 
15,502

(1)
Derivative contracts are shown on a gross basis prior to counterparty or cash collateral netting.

Credit related notes

Credit related notes in the table above include investments in securities issued by CDO, CLO and credit linked note vehicles. These instruments are classified as trading securities. Most of the entities that issue these instruments have either the ability to enter into, or have entered into, credit derivatives.

The carrying value of these instruments equals Merrill Lynch's maximum exposure to loss. Merrill Lynch is not obligated to make any payments to the entities under the terms of the securities owned. Merrill Lynch discloses internal categorizations (i.e., investment grade, non-investment grade) consistent with how risk is managed for these instruments.

Credit risk management of derivatives

Merrill Lynch defines counterparty credit risk as the potential for loss that can occur as a result of an individual, counterparty, or issuer being unable or unwilling to honor its contractual obligations. Merrill Lynch mitigates its credit risk to counterparties through a variety of techniques, including, where appropriate, the right to require initial collateral or margin, the right to terminate transactions or to obtain collateral should unfavorable events occur, the right to call for collateral when certain exposure thresholds are exceeded, the right to call for third party guarantees, and the purchase of credit default protection.

Merrill Lynch enters into International Swaps and Derivatives Association, Inc. (“ISDA”) master agreements or their equivalent (“master netting agreements”) with almost all derivative counterparties. Master netting agreements provide protection in bankruptcy in certain circumstances and, where legally enforceable, enable receivables and payables with the same counterparty to be offset for accounting and risk management purposes. Netting agreements are generally negotiated bilaterally and can require complex terms. While Merrill Lynch makes reasonable efforts to execute such agreements, it is possible that a counterparty may be unwilling to sign such an agreement and, as a result, would subject Merrill Lynch to additional credit risk.

Where Merrill Lynch has entered into legally enforceable netting agreements with counterparties, it reports derivative assets and liabilities, and any related cash collateral, net in the Condensed Consolidated Balance Sheets in accordance with ASC 210-20, Balance Sheet-Offsetting. At September 30, 2012 and December 31, 2011, cash collateral received of $30.1 billion and $26.5 billion, respectively, and cash collateral paid of $32.7 billion and $33.0 billion, respectively, was netted against derivative assets and liabilities. The enforceability of master netting agreements under bankruptcy laws in certain countries or in certain industries is not free from doubt, and receivables and payables with counterparties in these countries or industries are accordingly reported on a gross basis.

Monoline derivative credit exposure at September 30, 2012 had a notional value of $12.4 billion compared with $15.8 billion at December 31, 2011. The fair value of monoline derivative credit exposure was $1.1 billion at September 30, 2012 compared with $1.7 billion at December 31, 2011. At September 30, 2012, the CVA related to monoline derivative trading instruments exposure was $165 million compared with $382 million at December 31, 2011, which reduced Merrill Lynch's net exposure to $0.9 billion at September 30, 2012. Monoline related activity for the three and nine months ended September 30, 2012 resulted in gains of $55 million and $168 million, respectively, which consisted of credit valuation adjustments and exposure changes.

Bank of America has guaranteed the performance of Merrill Lynch on certain derivative transactions. The aggregate amount of such derivative liabilities was approximately $1.3 billion at September 30, 2012.
Credit-risk related contingent features

Most of Merrill Lynch's derivative contracts contain credit risk related contingent features, primarily in the form of 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 Merrill Lynch has transacted. These contingent features may be for the benefit of Merrill Lynch as well as its counterparties with respect to changes in Merrill Lynch's creditworthiness and the exposure under the derivative transactions. At September 30, 2012 and December 31, 2011, Merrill Lynch held cash and securities collateral of $40.7 billion and $40.9 billion and posted cash and securities collateral of $39.9 billion and $45.2 billion in the normal course of business under derivative agreements.

In connection with certain OTC derivative contracts and other trading agreements, Merrill Lynch 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 ML & Co. or certain subsidiaries. The amount of additional collateral required depends on the contract and is usually a fixed incremental amount and/or market value of the exposure.

At September 30, 2012, the amount of collateral, calculated based on the terms of the contracts that Merrill Lynch could be required to post to counterparties but had not yet posted to counterparties was approximately $1.7 billion.

Some counterparties are currently able to unilaterally terminate certain contracts, or Merrill Lynch may be required to take other action such as find a suitable replacement or obtain a guarantee. At September 30, 2012, the current liability for these derivative contracts was $1.0 billion, against which Merrill Lynch had posted $0.9 billion of collateral.

At September 30, 2012, if the rating agencies had downgraded their long-term senior debt ratings for ML & Co. or certain subsidiaries by one incremental notch, the amount of additional collateral contractually required by such derivative contracts and other trading agreements would have been approximately $0.5 billion. If the rating agencies had downgraded their long-term senior debt ratings for ML & Co. or certain subsidiaries by a second incremental notch, approximately $4.0 billion in additional collateral would have been required.

Also, if the rating agencies had downgraded their long-term senior debt ratings for ML & Co. 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 $2.7 billion, against which $2.0 billion of collateral had been posted. Further, if the rating agencies had downgraded their long-term debt ratings for ML & Co. or 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 $1.3 billion, against which $0.7 billion of collateral had been posted.

Valuation Adjustments on Derivatives

Merrill Lynch records credit risk valuation adjustments on derivatives in order to properly reflect the credit quality of the counterparties on the value of the derivatives. Merrill Lynch 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 legally 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, Merrill Lynch 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 such as 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 CVA. Independently, counterparty credit spreads may tighten, which would result in an offsetting decrease to CVA.

Merrill Lynch may enter into economic hedges to offset market driven exposures. Merrill Lynch often hedges the counterparty spread risk in CVA with credit default swaps and often hedges the other market risks in both CVA and DVA primarily with currency and interest rate swaps. Since the components of the valuation adjustments on derivatives move independently and Merrill Lynch 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, Merrill Lynch refined its methodology for calculating valuation adjustments on derivatives on a prospective basis. Merrill Lynch no longer considers the probability of default for both the counterparty and Merrill Lynch when calculating the counterparty CVA and DVA and now only considers the probability of the counterparty defaulting for CVA and Merrill Lynch defaulting for DVA. This change in estimate increased CVA by $51 million and DVA by $85 million for both the three and nine months ended September 30, 2012, with a net gain of $34 million. 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 Merrill Lynch on a gross and net of hedges basis, which are recorded in principal transactions revenues.

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)
$
304

$
100

 
$
(963
)
$
(312
)
 
$
454

$
275

 
$
(1,454
)
$
(1,051
)
Derivative liabilities (DVA) (2)
(288
)
(252
)
 
759

765

 
(893
)
(1,020
)
 
692

648

(1)
At September 30, 2012 and December 31, 2011, the cumulative counterparty credit risk valuation adjustment reduced the derivative assets balance by $1.3 billion and $1.5 billion.
(2)
At September 30, 2012 and December 31, 2011, Merrill Lynch's cumulative DVA reduced the derivative liabilities balance by $0.5 billion and $1.1 billion.