Bank of America 2007 Annual Report Download - page 122

exchange cash flows based on specified underlying notional amounts,
assets and/or indices. Financial futures and forward settlement contracts
are agreements to buy or sell a quantity of a financial instrument, index,
currency or commodity at a predetermined future date, and rate or price.
An option contract is an agreement that conveys to the purchaser the
right, but not the obligation, to buy or sell a quantity of a financial instru-
ment (including another derivative financial instrument), index, currency or
commodity at a predetermined rate or price during a period or at a time in
the future. Option agreements can be transacted on organized exchanges
or directly between parties. The Corporation also provides credit
derivatives to customers who wish to increase or decrease credit
exposures. In addition, the Corporation utilizes credit derivatives to man-
age the credit risk associated with the loan portfolio.
All derivatives are recognized on the Consolidated Balance Sheet at
fair value, taking into consideration the effects of legally enforceable
master netting agreements that allow the Corporation to settle positive
and negative positions and offset cash collateral held with the same coun-
terparty on a net basis. For exchange-traded contracts, fair value is based
on quoted market prices. For non-exchange traded contracts, fair value is
based on dealer quotes, pricing models, discounted cash flow method-
ologies, or similar techniques for which the determination of fair value may
require significant management judgment or estimation.
Valuations of derivative assets and liabilities reflect the value of the
instrument including the values associated with counterparty risk. With
the issuance of SFAS 157, these values must also take into account the
Corporation’s own credit standing, thus including in the valuation of
the derivative instrument the value of the net credit differential between
the counterparties to the derivative contract. Effective January 1, 2007,
the Corporation updated its methodology to include the impact of both the
counterparty and its own credit standing.
Prior to January 1, 2007, the Corporation recognized gains and
losses at inception of a derivative contract only if the fair value of the con-
tract was evidenced by a quoted market price in an active market, an
observable price or other market transaction, or other observable data
supporting a valuation model in accordance with EITF Issue No. 02-3,
“Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities” (EITF 02-3). For those gains and losses not evidenced by the
above mentioned market data, the transaction price was used as the fair
value of the derivative contract. Any difference between the transaction
price and the model fair value was considered an unrecognized gain or
loss at inception of the contract. These unrecognized gains and losses
were recorded in income using the straight line method of amortization
over the contractual life of the derivative contract. The adoption of SFAS
157 on January 1, 2007, eliminated the deferral of these gains and
losses resulting in the recognition of previously deferred gains and losses
as an increase to the beginning balance of retained earnings by a pre-tax
amount of $22 million.
Trading Derivatives and Economic Hedges
The Corporation designates at inception whether the derivative contract is
considered hedging or non-hedging for SFAS 133 accounting purposes.
Derivatives held for trading purposes are included in derivative assets or
derivative liabilities with changes in fair value reflected in trading account
profits (losses).
Derivatives used as economic hedges but not designated in a hedg-
ing relationship for accounting purposes are also included in derivative
assets or derivative liabilities. Changes in the fair value of derivatives that
serve as economic hedges of mortgage servicing rights (MSRs), interest
rate lock commitments (IRLCs) and first mortgage loans held-for-sale that
are originated by the Corporation are recorded in mortgage banking
income. Changes in the fair value of derivatives that serve as asset and
liability management (ALM) economic hedges, which do not qualify or were
not designated as accounting hedges, are recorded in other income. Credit
derivatives used by the Corporation do not qualify for hedge accounting
under SFAS 133 despite being effective economic hedges with changes in
the fair value of these derivatives included in other income.
Derivatives Used For SFAS 133 Hedge Accounting Purposes
For SFAS 133 hedges, the Corporation formally documents at inception all
relationships between hedging instruments and hedged items, as well as
its risk management objectives and strategies for undertaking various
accounting hedges. Additionally, the Corporation uses dollar offset or
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. The Corporation dis-
continues hedge accounting when it is determined that a derivative is not
expected to be or has ceased to be highly effective as a hedge, and then
reflects changes in fair value of the derivative in earnings after termination
of the hedge relationship.
The Corporation uses its derivatives designated as hedging for
accounting purposes as either fair value hedges, cash flow hedges or
hedges of net investments in foreign operations. The Corporation manages
interest rate and foreign currency exchange rate sensitivity predominantly
through the use of derivatives. Fair value hedges are used to protect
against changes in the fair value of the Corporation’s assets and liabilities
that are due to interest rate or foreign exchange volatility. Cash flow
hedges are used to minimize the variability in cash flows of assets or
liabilities, or forecasted transactions caused by interest rate or foreign
exchange fluctuation. For terminated cash flow hedges, the maximum
length of time over which forecasted transactions are hedged is 28 years,
with a substantial portion of the hedged transactions being less than 10
years. For open cash flow hedges, the maximum length of time over which
forecasted transactions are hedged is less than seven years. Changes in
the fair value of derivatives designated as fair value hedges are recorded
in earnings, together and in the same income statement line item with
changes in the fair value of the related hedged item. Changes in the fair
value of derivatives designated as cash flow hedges are recorded in
accumulated other comprehensive income (OCI) and are reclassified into
the line item in the Consolidated Statement of Income in which the hedged
item is recorded in the same period the hedged item affects earnings.
Hedge ineffectiveness and gains and losses on the excluded component
of a derivative in assessing hedge effectiveness are recorded in earnings
in the same income statement line item that is used to record hedge
effectiveness. SFAS 133 retains certain concepts of SFAS No. 52,
“Foreign Currency Translation,” (SFAS 52) for foreign currency exchange
hedging. Consistent with SFAS 52, the Corporation records changes in the
fair value of derivatives used as hedges of the net investment in foreign
operations, to the extent effective, as a component of accumulated OCI.
If a derivative instrument in a fair value hedge is terminated or the
hedge designation removed, the previous adjustments to the carrying
amount of the hedged asset or liability are subsequently accounted for in
the same manner as other components of the carrying amount of that
asset or liability. For interest-earning assets and interest-bearing liabilities,
such adjustments are amortized to earnings over the remaining life of the
respective asset or liability. If a derivative instrument in a cash flow hedge
is terminated or the hedge designation is removed, related amounts in
120 Bank of America 2007