Bank of America 2006 Annual Report Download - page 83

The Corporation uses interest rate derivative instruments to hedge
the variability in the cash flows of its assets and liabilities, and other fore-
casted transactions (cash flow hedges). The net losses on both open and
closed derivative instruments recorded in Accumulated OCI net-of-tax at
December 31, 2006 was $3.7 billion. These net losses are expected to
be reclassified into earnings in the same period when the hedged cash
flows affect earnings and will decrease income or increase expense on the
respective hedged cash flows. Assuming no change in open cash flow
derivative hedge positions and no changes to interest rates beyond what
is implied in forward yield curves at December 31, 2006, the net losses
are expected to be reclassified into earnings as follows: $1.0 billion (pre-
tax), or 18 percent, within the next year, 58 percent within five years, 83
percent within 10 years, with the remaining 17 percent thereafter. For
more information on derivatives designated as cash flow hedges, see Note
4 of the Consolidated Financial Statements.
The amount included in Accumulated OCI for terminated derivative
contracts were losses of $3.2 billion and $2.5 billion, net-of-tax, at
December 31, 2006 and 2005. The increase in losses can be attributable
primarily to losses in the value of interest rate derivatives that were termi-
nated during the year. Losses on these terminated derivative contracts are
reclassified into earnings in the same period or periods during which the
hedged forecasted transaction affects earnings.
Mortgage Banking Risk Management
Interest rate lock commitments (IRLCs) on loans intended to be sold are
subject to interest rate risk between the date of the IRLC and the date the
loan is funded. Residential first mortgage loans held-for-sale are subject to
interest rate risk from the date of funding until the loans are sold to the
secondary market. To hedge interest rate risk, we utilize forward loan sale
commitments and other derivative instruments including purchased
options. These instruments are used either as an economic hedge of
IRLCs and residential first mortgage loans held-for-sale, or designated as a
cash flow hedge of residential first mortgage loans held-for-sale, in which
case their net-of-tax unrealized gains and losses are included in Accumu-
lated OCI. At December 31, 2006, the notional amount of derivatives
economically hedging the IRLCs and residential first mortgage loans
held-for-sale was $15.0 billion.
We manage changes in the value of MSRs by entering into derivative
financial instruments. MSRs are a nonfinancial asset created when the
underlying mortgage loan is sold to investors and we retain the right to
service the loan. We use certain derivatives such as options and interest
rate swaps as economic hedges of MSRs. At December 31, 2006, the
amount of MSRs identified as being hedged by derivatives was approx-
imately $2.9 billion. The notional amount of the derivative contracts des-
ignated as economic hedges of MSRs at December 31, 2006 was $44.9
billion. The changes in the fair values of the derivative contracts are sub-
stantially offset by changes in the values of the MSRs that are hedged by
these derivative contracts. During 2006, the increase in value attributed to
economically hedged MSRs was $414 million offset by derivative hedge
losses of $200 million.
The Corporation adopted SFAS No. 156 “Accounting for Servicing of
Financial Assets” and accounts for consumer-related MSRs using the fair
value measurement method on January 1, 2006. See Note 1 of the Con-
solidated Financial Statements for additional information as it relates to
this accounting standard. See Note 8 of the Consolidated Financial State-
ments for additional information on MSRs.
Operational Risk Management
Operational risk is the risk of loss resulting from inadequate or failed
internal processes, people and systems, including system conversions
and integration, and external events. Successful operational risk manage-
ment is particularly important to diversified financial services companies
because of the nature, volume and complexity of the financial services
business.
We approach operational risk from two perspectives: enterprise-wide
and line of business-specific. The Compliance and Operational Risk
Committee provides oversight of significant company-wide operational and
compliance issues. Within Global Risk Management, Enterprise Com-
pliance and Operational Risk Management develops policies, practices,
controls and monitoring tools for assessing and managing operational
risks across the Corporation. We also mitigate operational risk through a
broad-based approach to process management and process improvement.
Improvement efforts are focused on reduction of variation in outputs. We
have a dedicated Quality and Productivity team to manage and certify the
process management and improvement efforts. For selected risks, we use
specialized support groups, such as Information Security and Supply Chain
Management, to develop corporate-wide risk management practices, such
as an information security program and a supplier program to ensure that
suppliers adopt appropriate policies and procedures when performing work
on behalf of the Corporation. These specialized groups also assist the
lines of business in the development and implementation of risk manage-
ment practices specific to the needs of the individual businesses. These
groups also work with line of business executives and risk executives to
develop appropriate policies, practices, controls and monitoring tools for
each line of business. Through training and communication efforts, com-
pliance and operational risk awareness is driven across the Corporation.
The lines of business are responsible for all the risks within the
business line, including operational risks. Operational and Compliance
Risk executives, working in conjunction with senior line of business execu-
tives, have developed key tools to help manage, monitor and report opera-
tional risk in each business line. Examples of these include personnel
management practices, data reconciliation processes, fraud management
units, transaction processing monitoring and analysis, business recovery
planning, and new product introduction processes. In addition, the lines of
business are responsible for monitoring adherence to corporate practices.
Management uses a self-assessment process, which helps to identify and
evaluate the status of risk issues, including mitigation plans, as appro-
priate. The goal of the self-assessment process is to periodically assess
changing market and business conditions and to evaluate key operational
risks impacting each line of business. In addition to information gathered
from the self-assessment process, key operational risk indicators have
been developed and are used to help identify trends and issues on both a
corporate and a business line level.
Recent Accounting and Reporting
Developments
See Note 1 of the Consolidated Financial Statements for a discussion of
recently issued or proposed accounting pronouncements.
Complex Accounting Estimates
Our significant accounting principles, as described in Note 1 of the Con-
solidated Financial Statements, are essential in understanding Manage-
ment’s Discussion and Analysis of Financial Condition and Results of
Operations. Many of our significant accounting principles require complex
judgments to estimate values of assets and liabilities. We have proce-
dures and processes to facilitate making these judgments.
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