Quarterly report pursuant to Section 13 or 15(d)

Derivatives

v2.4.0.8
Derivatives
 6 Months Ended
Jun. 30, 2013
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. 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 the three and six months ended June 30, 2013 and June 30, 2012 included the following:
Fair value hedges

The table below summarizes certain information related to fair value hedges for the three and six months ended June 30, 2013 and June 30, 2012, including hedges of interest rate risk on long-term borrowings that were adjusted and redesignated as part of Bank of America's acquisition of Merrill Lynch. At redesignation, the fair value of the derivatives was negative. As the derivatives mature, their fair value will approach zero. As a result, ineffectiveness may occur and the fair value changes in the derivatives and the long-term borrowings 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 borrowings attributable to interest rate risk.

(dollars in millions)
 
 
 
 
 
 
 
 
2013
 
2012
 
Derivative (1)
Hedged Item (1)(2)
Hedge Ineffectiveness (1)
 
Derivative (1)
Hedged Item (1)(2)
Hedge Ineffectiveness (1)
For the three months ended June 30:
 
 
 
 
 
 
 
Interest rate risk on USD denominated long-term borrowings
$
(732
)
$
658

$
(74
)
 
$
471

$
(645
)
$
(174
)
Interest rate risk on foreign currency denominated long-term borrowings
(94
)
61

(33
)
 
(412
)
345

(67
)
Commodity price risk on commodity inventory
3

(4
)
(1
)
 
(9
)
9

—

 
 
 
 
 
 
 
 
For the six months ended June 30:
 
 
 
 
 
 
 
Interest rate risk on USD denominated long-term borrowings
(1,081
)
905

(176
)
 
60

(371
)
(311
)
Interest rate risk on foreign currency denominated long-term borrowings
(615
)
533

(82
)
 
(324
)
230

(94
)
Commodity price risk on commodity inventory
—

(1
)
(1
)
 
14

(14
)
—

 
 
 
 
 
 
 
 
 
2013
 
 
2012
 
 
 Trading Assets
 Trading Liabilities
 
 
 Trading Assets
 Trading Liabilities
 
 
 
 
 
 
 
 
 
As of June 30, 2013 and December 31, 2012:
 
 
 
 
 
 
 
Carrying value of hedging derivatives:
 
 
 
 
 
 
 
Long-term borrowings
$
4,006

$
732

 
 
$
5,706

$
664

 
Commodity inventory
36

—

 
 
48

2

 
Notional amount of hedging derivatives:
 
 
 
 
 
 
 
Long-term borrowings
29,352

8,747

 
 
36,932

9,676

 
Commodity inventory
99

4

 
 
124

3

 
(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)
 
 
 
 
 
 
 
 
 
2013
 
 
 
2012
 
 
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 June 30:
 
 

 
 
 
 

 
Foreign exchange risk
$
563

$
3

$
(54
)
 
$
555

$
4

$
(100
)
 
 
 
 
 
 
 
 
For the six months ended June 30:
 
 
 
 
 
 
 
Foreign exchange risk
1,608

(91
)
(78
)
 
110

(37
)
(98
)
 
 
 
 
 
 
 
 
 
 
2013
 
 
 
2012
 
As of June 30, 2013 and December 31, 2012:
 
 
 
 
 
 
 
Carrying value of hedging derivatives:
 
 
 
 
 
 
 
   Trading assets
 
$
622

 
 
 
$
425

 
   Trading liabilities
 
375

 
 
 
618

 
Notional amount of hedging derivatives:
 
 
 
 
 
 
 
   in an asset position
 
23,655

 
 
 
5,140

 
   in a liability position
 
5,603

 
 
 
19,391

 
 
 
 
 
 
 
 
 
(1) 
Amounts are recorded in other revenues and are attributable to certain legal entity liquidations.

Other Risk Management Derivatives

Other risk management derivatives are used by Merrill Lynch 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 net gains (losses) on these derivatives for the three and six months ended June 30, 2013 and June 30, 2012. These net gains (losses) are largely offset by the income or expense that is recorded on the hedged item.
Net gains (losses) on other risk management derivatives
(dollars in millions)
 
 
 
 
 
 
2013(1)
 
2012(1)
For the three months ended June 30:
 
 
 
 
Interest rate risk
 
$
(33
)
 
$
17

Foreign currency risk
 
47

 
(703
)
Credit risk
 
(8
)
 
18

 
 
 
 
 
For the six months ended June 30:
 
 
 
 
Interest rate risk
 
(41
)
 
11

Foreign currency risk
 
(468
)
 
(504
)
Credit risk
 
1

 
(31
)
(1) 
Amounts are recorded in other revenues and interest expense.

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 June 30, 2013 and December 31, 2012. 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 June 30, 2013
 
Contract/
Notional
 
Trading Assets-
Derivative Contracts
 
Contract/
Notional
 
Trading Liabilities-
Derivative Contracts
Interest rate contracts
 

 
 

 
 

 
 

Swaps
$
7,255,357

 
$
358,097

 
$
7,023,069

 
$
353,628

Futures and forwards
1,959,751

 
3,823

 
1,975,339

 
3,776

Written options
—

 
—

 
1,290,002

 
48,153

Purchased options
1,250,956

 
49,973

 
—

 
—

Foreign exchange contracts
 
 
 
 
 
 
 
Swaps
724,881

 
22,234

 
734,131

 
24,889

Spot, futures and forwards
145,484

 
3,136

 
150,434

 
3,883

Written options
—

 
—

 
278,187

 
6,455

Purchased options
276,029

 
6,693

 
—

 
—

Equity contracts
 
 
 
 
 
 
 
Swaps
30,181

 
1,798

 
33,217

 
2,127

Futures and forwards
29,454

 
1,370

 
34,649

 
1,111

Written options
—

 
—

 
316,774

 
20,268

Purchased options
307,234

 
18,106

 
—

 
—

Commodity contracts
 
 
 
 
 
 
 
Swaps
53,766

 
4,180

 
11,810

 
4,947

Futures and forwards
308,763

 
5,700

 
271,649

 
3,949

Written options
—

 
—

 
216,616

 
7,986

Purchased options
222,445

 
8,005

 
—

 
—

Credit derivatives
 

 
 

 
 

 
 

Purchased protection:
 

 
 

 
 

 
 

Credit default swaps
111,975

 
8,446

 
90,255

 
1,784

Total return swaps
6,611

 
690

 
4,169

 
1,173

Other credit derivatives
4,022

 
20

 
13

 
—

Written protection:
 

 
 

 
 
 
 
Credit default swaps
90,486

 
2,281

 
109,232

 
7,878

Total return swaps
3,800

 
120

 
13,750

 
235

Other credit derivatives
—

 
—

 
3,805

 
16

Gross derivative assets/liabilities
$
12,781,195

 
$
494,672

 
$
12,557,101

 
$
492,258

Less: Legally enforceable master netting
 
 
(440,896
)
 
 
 
(440,896
)
Less: Cash collateral received/paid
 

 
(26,143
)
 
 

 
(26,189
)
Total derivative assets and liabilities
 

 
$
27,633

 
 

 
$
25,173

 
 
 
 
 
 
 
 
 
(dollars in millions)
 
As of December 31, 2012
 
Contract/
Notional
 
Trading Assets-
Derivative Contracts
 
Contract/
Notional
 
Trading Liabilities-
Derivative Contracts
Interest rate contracts
 

 
 

 
 

 
 

Swaps
$
7,887,346

 
$
519,123

 
$
7,963,410

 
$
514,689

Futures and forwards
2,245,535

 
1,661

 
2,257,693

 
1,423

Written options
—

 
—

 
1,333,460

 
64,295

Purchased options
1,271,613

 
67,251

 
—

 
—

Foreign exchange contracts
 

 
 

 
 

 
 

Swaps
752,596

 
26,797

 
793,944

 
32,918

Spot, futures and forwards
124,702

 
2,740

 
131,334

 
3,272

Written options
—

 
—

 
211,069

 
5,154

Purchased options
194,435

 
4,770

 
—

 
—

Equity contracts
 

 
 

 
 

 
 

Swaps
29,719

 
1,077

 
25,139

 
1,274

Futures and forwards
24,113

 
966

 
33,532

 
1,015

Written options
—

 
—

 
257,345

 
15,402

Purchased options
246,517

 
14,216

 
—

 
—

Commodity contracts
 

 
 

 
 

 
 

Swaps
28,057

 
2,477

 
26,140

 
3,990

Futures and forwards
258,703

 
4,759

 
240,179

 
2,663

Written options
—

 
—

 
163,516

 
7,256

Purchased options
164,633

 
7,042

 
—

 
—

Credit derivatives
 

 
 

 
 

 
 

Purchased protection:
 

 
 

 
 

 
 

Credit default swaps
103,042

 
9,644

 
103,839

 
2,120

Total return swaps
7,807

 
691

 
5,003

 
1,226

Other credit derivatives
215

 
1

 
13

 
—

Written protection:
 

 
 

 
 

 
 
Credit default swaps
102,888

 
2,640

 
103,988

 
8,947

Total return swaps
7,204

 
133

 
13,761

 
207

Other credit derivatives
—

 
1

 
212

 
2

Gross derivative assets/liabilities
$
13,449,125

 
$
665,989

 
$
13,663,577

 
$
665,853

Less: Legally enforceable master netting
 

 
(613,145
)
 
 

 
(613,145
)
Less: Cash collateral received/paid
 

 
(27,993
)
 
 

 
(32,140
)
Total derivative assets and liabilities
 

 
$
24,851

 
 

 
$
20,568

 
 
 
 
 
 
 
 

Offsetting of Derivatives

Merrill Lynch enters into International Swaps and Derivatives Association, Inc. (“ISDA”) master netting agreements or similar agreements with substantially all of its derivative counterparties. These legally enforceable master netting agreements give Merrill Lynch, in the event of default by the counterparty, the right to liquidate securities held as collateral and to offset receivables and payables with the same counterparty. For purposes of the Condensed Consolidated Balance Sheet, Merrill Lynch offsets derivative assets and liabilities and cash collateral held with the same counterparty where it has such a legally enforceable master netting agreement.

The following table presents derivative instruments included in derivative assets and liabilities on Merrill Lynch's Condensed Consolidated Balance Sheets at June 30, 2013 and December 31, 2012 by primary risk (e.g., interest rate risk) and the platform, where applicable, on which these derivatives are transacted. Exchange-traded derivatives include listed options transacted on an exchange. Over-the-counter derivatives include bilateral transactions between Merrill Lynch and a particular counterparty. Over-the-counter cleared derivatives include bilateral transactions between Merrill Lynch and a counterparty where the transaction is cleared through a clearinghouse. Balances are presented on a gross basis, prior to the application of counterparty and cash collateral netting. Total gross 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.

Other gross derivative assets and liabilities in the table represents derivatives entered into under master netting agreements where uncertainty exists as to the enforceability of these agreements under bankruptcy laws in some countries or industries and accordingly, receivables and payables with counterparties in these countries or industries are reported on a gross basis.

Also included in the table is financial instrument collateral related to legally enforceable master netting agreements that represents securities collateral received or pledged and customer cash collateral held at third-party custodians. These amounts are not offset on the Condensed Consolidated Balance Sheets but are shown as a reduction to total derivative assets and liabilities in the table to derive net derivative assets or liabilities.

For information on the offsetting of securities financing agreements, see Note 7.
Offsetting of Derivatives
 
 
 
 
 
 
 
 
June 30, 2013
 
December 31, 2012
(Dollars in millions)
Trading Assets-
Derivative Contracts
 
Trading Liabilities-
Derivative Contracts
 
Trading Assets-
Derivative Contracts
 
Trading Liabilities-
Derivative Contracts
Interest rate contracts
 
 
 
 
 
 
 
Over-the-counter
$
254,047

 
$
244,853

 
$
343,399

 
$
331,403

Over-the-counter-cleared
156,459

 
159,313

 
244,464

 
247,894

Foreign exchange contracts
 
 
 
 
 
 
 
Over-the-counter
31,080

 
33,682

 
33,348

 
39,803

Equity contracts
 

 
 
 
 

 
 
Over-the-counter
12,162

 
12,193

 
9,782

 
10,521

Exchange-traded
6,757

 
7,501

 
4,776

 
4,682

Commodity contracts
 
 
 
 
 
 
 
Over-the-counter
9,402

 
9,936

 
6,798

 
7,684

Exchange-traded
3,348

 
3,115

 
3,421

 
3,192

Credit contracts
 

 
 

 
 

 
 

Over-the-counter
9,967

 
10,322

 
11,560

 
11,802

Over-the-counter-cleared
342

 
343

 
294

 
226

Total gross derivative assets/liabilities, before netting
 
 
 
 
 
 
 
Over-the-counter
$
316,658

 
$
310,986

 
$
404,887

 
$
401,213

Exchange-traded
$
10,105

 
$
10,616

 
$
8,197

 
$
7,874

Over-the-counter-cleared
$
156,801

 
$
159,656

 
$
244,758

 
$
248,120

Less: Legally enforceable master netting and cash collateral received/paid
 
 
 
 
 
 
 
Over-the-counter
(303,128
)
 
(300,331
)
 
(390,608
)
 
(394,755
)
Exchange-traded
(7,110
)
 
(7,110
)
 
(5,880
)
 
(5,880
)
Over-the-counter-cleared
(156,801
)
 
(159,644
)
 
(244,650
)
 
(244,650
)
Derivative assets/liabilities, after netting
16,525

 
14,173

 
16,704

 
11,922

Other gross derivative assets/liabilities
11,108

 
11,000

 
8,147

 
8,646

Total derivative assets/liabilities
27,633

 
25,173

 
24,851

 
20,568

Less: Financial instruments collateral (1)
(2,729
)
 
(968
)
 
(2,832
)
 
(1,549
)
Total net derivative assets/liabilities
$
24,904

 
$
24,205

 
$
22,019

 
$
19,019

(1)
These amounts are limited to the derivative asset/liability balance and, accordingly, do not include excess collateral received/pledged.

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.

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, 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 Earnings (Loss). For equity securities, commissions related to purchases and sales are recorded in commissions on the Condensed Consolidated Statements of Earnings (Loss). 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.

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 six months ended June 30, 2013 and June 30, 2012.

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 June 30, 2013

(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
322

 
$
24

 
$
6

 
$
198

 
$
550

Foreign exchange risk
73

 
—

 
10

 
—

 
83

Equity risk
1,118

 
758

 
16

 
(426
)
 
1,466

Commodity risk
118

 
—

 
2

 
(23
)
 
97

Credit risk
240

 
—

 
63

 
446

 
749

Total trading related
1,871

 
782

 
97

 
195

 
2,945

Non-trading related
33

 
628

 
11

 
(464
)
 
208

Total
$
1,904

 
$
1,410

 
$
108

 
$
(269
)
 
$
3,153

 
 
 
 
 
 
 
 
 
 

For The Six Months Ended June 30, 2013
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
727

 
$
45

 
$
6

 
$
414

 
$
1,192

Foreign exchange risk
182

 
—

 
35

 
—

 
217

Equity risk
1,779

 
1,490

 
43

 
(450
)
 
2,862

Commodity risk
280

 
—

 
4

 
(45
)
 
239

Credit risk
1,044

 
—

 
(420
)
 
955

 
1,579

Total trading related
4,012

 
1,535

 
(332
)
 
874

 
6,089

Non-trading related
36

 
1,254

 
58

 
(972
)
 
376

Total
$
4,048

 
$
2,789

 
$
(274
)
 
$
(98
)
 
$
6,465

 
 
 
 
 
 
 
 
 
 

For The Three Months Ended June 30, 2012
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues(1)
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
209

 
$
19

 
$
4

 
$
165

 
$
397

Foreign exchange risk
35

 
—

 
—

 
—

 
35

Equity risk
1,356

 
613

 
22

 
(1,019
)
 
972

Commodity risk
95

 
—

 
1

 
(30
)
 
66

Credit risk
249

 
—

 
(11
)
 
545

 
783

Total trading related
1,944

 
632

 
16

 
(339
)
 
2,253

Non-trading related
4

 
608

 
236

 
(614
)
 
234

Total
$
1,948

 
$
1,240

 
$
252

 
$
(953
)
 
$
2,487

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

For The Six Months Ended June 30, 2012
(dollars in millions)
 
Principal
Transactions
 
Commissions
 
Other Revenues(1)
 
Net Interest
(Expense) Income
 
Total
Interest rate risk
$
378

 
$
37

 
$
4

 
$
372

 
$
791

Foreign exchange risk
60

 
—

 
—

 
—

 
60

Equity risk
1,776

 
1,332

 
42

 
(969
)
 
2,181

Commodity risk
355

 
—

 
1

 
(58
)
 
298

Credit risk
1,399

 
—

 
66

 
1,077

 
2,542

Total trading related
3,968

 
1,369

 
113

 
422

 
5,872

Non-trading related
(2,186
)
 
1,226

 
916

 
(1,391
)
 
(1,435
)
Total
$
1,782

 
$
2,595

 
$
1,029

 
$
(969
)
 
$
4,437

 
 
 
 
 
 
 
 
 
 
(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 June 30, 2013:
 

 
 

 
 

 
 

 
 

 
 

Derivative contracts:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

Investment grade(2)
$
153,899

 
$
27,179

 
$
39,905

 
$
80,247

 
$
6,568

 
$
1,874

Non-investment grade(2)
67,174

 
13,924

 
13,046

 
19,298

 
20,906

 
6,255

Total credit derivatives
221,073

 
41,103

 
52,951

 
99,545

 
27,474

 
8,129

Credit related notes:
 

 
 

 
 

 
 

 
 

 
 

Investment grade(2)
3,450

 
32

 
14

 
28

 
3,376

 
3,450

Non-investment grade(2)
1,547

 
45

 
160

 
207

 
1,135

 
1,547

Total credit related notes
4,997

 
77

 
174

 
235

 
4,511

 
4,997

Total derivative contracts
$
226,070

 
$
41,180

 
$
53,125

 
$
99,780

 
$
31,985

 
$
13,126

At December 31, 2012:
 

 
 

 
 

 
 

 
 

 
 

Derivative contracts:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives:
 

 
 

 
 

 
 

 
 

 
 

Investment grade(2)
$
160,390

 
$
34,454

 
$
42,871

 
$
70,645

 
$
12,420

 
$
1,855

Non-investment grade(2)
67,663

 
10,753

 
19,962

 
17,911

 
19,037

 
7,301

Total credit derivatives
228,053

 
45,207

 
62,833

 
88,556

 
31,457

 
9,156

Credit related notes:
 
 
 
 
 
 
 
 
 
 
 
Investment grade(2)
3,201

 
4

 
7

 
163

 
3,027

 
3,201

Non-investment grade(2)
1,445

 
115

 
141

 
271

 
918

 
1,445

  Total credit related notes
4,646

 
119

 
148

 
434

 
3,945

 
4,646

Total derivative contracts
$
232,699

 
$
45,326

 
$
62,981

 
$
88,990

 
$
35,402

 
$
13,802

 
 
 
 
 
 
 
 
 
 
 
 
(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 June 30, 2013 and December 31, 2012, 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 June 30, 2013:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives purchased
$
129,273

 
$
25,347

 
$
36,754

 
$
50,195

 
$
16,977

 
$
3,826

Credit derivatives sold
132,516

 
20,451

 
38,077

 
52,605

 
21,383

 
4,943

At December 31, 2012:
 

 
 

 
 

 
 

 
 

 
 

Credit derivatives purchased
131,643

 
31,576

 
38,844

 
41,800

 
19,423

 
4,208

Credit derivatives sold
138,479

 
29,881

 
41,986

 
43,399

 
23,213

 
5,235

(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 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 ISDA master netting agreements or similar agreements with substantially all of its derivative counterparties. 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.

At June 30, 2013 and December 31, 2012, cash collateral received of $26.1 billion and $28.0 billion, respectively, and cash collateral paid of $26.2 billion and $32.1 billion, respectively, was netted against derivative assets and liabilities.

Monoline derivative credit exposure at June 30, 2013 had a notional value of $11.2 billion compared with $12.1 billion at December 31, 2012. The fair value of the monoline derivative credit exposure was $0.4 billion at June 30, 2013 compared with $0.9 billion at December 31, 2012. At June 30, 2013, the CVA related to monoline derivative trading instruments exposure was $44 million compared with $117 million at December 31, 2012, which reduced Merrill Lynch's net exposure to $332 million at June 30, 2013. Monoline related activity for the three and six months ended June 30, 2013 resulted in gains of $18 million and $57 million, respectively, which primarily consisted of CVA 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 June 30, 2013.

In addition, at December 31, 2012, Merrill Lynch had $1.3 billion of net monoline exposure with MBIA, Inc. and certain of its affiliates (“MBIA”), which was included within Interest and other receivables. These contracts were not considered to be derivative trading instruments because of the inherent default risk and they did not provide a hedge benefit. During the three months ended March 31, 2013, Merrill Lynch recorded a charge of $450 million to write down its receivable from MBIA, which was recorded as a reduction to Other revenues in that period.

On May 7, 2013, Bank of America entered into a comprehensive settlement (the “MBIA Settlement”) with MBIA to resolve all outstanding litigation between the parties, as well as other claims between the parties. Under the MBIA Settlement, all pending litigation between the parties was dismissed and each party received a global release of those claims. In connection with the MBIA Settlement, the parties also terminated various CDS transactions in connection with CMBS. Collectively, those CDS transactions had a notional value of $7.4 billion and a fair value of $813 million as of March 31, 2013, and, in connection with the MBIA Settlement, MBIA terminated its CDS with Merrill Lynch, and Bank of America paid Merrill Lynch the value of such terminated CDS.
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 June 30, 2013 and December 31, 2012, Merrill Lynch held cash and securities collateral of $37.0 billion and $38.2 billion and posted cash and securities collateral of $31.2 billion and $38.3 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 June 30, 2013, 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 $0.8 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 June 30, 2013, the current liability for these derivative contracts was $0.2 billion, against which Merrill Lynch had posted $0.2 billion of collateral.

At June 30, 2013, 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 derivative contracts and other trading agreements would have been approximately $0.4 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 $4.1 billion in additional incremental 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 June 30, 2013 was $1.2 billion, against which $0.7 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 June 30, 2013 was an incremental $1.0 billion, against which $0.6 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 and its own credit quality 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 spreads 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 risk management activities to offset market driven exposures. Merrill Lynch often hedges the counterparty spread risk in CVA with CDS 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).

In early 2013, Merrill Lynch refined its methodology for calculating CVA and DVA, on a prospective basis, to adjust the way it values mutual termination clauses in derivatives contracts and to more fully incorporate the potential for the counterparties to default prior to a change in their credit ratings. This change in estimates increased both CVA and DVA by approximately $206 million for the quarter ended March 31, 2013. The resulting net earnings impact was not material. The net CVA and DVA excluding the impact of these refinements was a gain of $195 million and a gain of $3 million, respectively, for the six months ended June 30, 2013.

The Valuation Adjustments on Derivatives table below 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 June 30
 
Six Months Ended June 30
 
2013
 
2012
 
2013
 
2012
(dollars in millions)
Gross
Net
 
Gross
Net
 
Gross
Net
 
Gross
Net
Derivative assets (CVA) (1)
$
53

$
91

 
$
(100
)
$
(52
)
 
$
(23
)
$
(11
)
 
$
149

$
173

Derivative liabilities (DVA) (2)
101

80

 
19

(73
)
 
225

209

 
(606
)
(770
)
(1) 
At June 30, 2013 and December 31, 2012, the cumulative counterparty credit risk valuation adjustment reduced the derivative assets balance by $1.2 billion and $1.1 billion, respectively.
(2) 
At June 30, 2013 and December 31, 2012, Merrill Lynch's cumulative DVA reduced the derivative liabilities balance by $0.6 billion and $0.4 billion, respectively.