Bank of America 2011 Annual Report Download - page 156

154 Bank of America 2011
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 instrument (including another
derivative financial instrument), index, currency or commodity at
a predetermined rate or price during a period or at a date in the
future. Option agreements can be transacted on organized
exchanges or directly between parties.
All derivatives are recorded 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 counterparty 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 methodologies 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 counterparty credit risk. These values
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.
Trading Derivatives and Economic Hedges
Derivatives held for trading purposes are included in derivative
assets or derivative liabilities with changes in fair value included
in trading account profits (losses).
Derivatives used as economic hedges, because either they did
not qualify for or were not designated as an accounting hedge, 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 (LHFS) that are
originated by the Corporation are recorded in mortgage banking
income. Changes in the fair value of derivatives that serve as
economic hedges of credit exposures, interest rate risk and foreign
currency exposures are included in other income (loss). Credit
derivatives used by the Corporation as economic hedges do not
qualify as accounting hedges but can protect the Corporation from
various credit exposures as economic hedges, and changes in the
fair value of these derivatives are included in other income (loss).
Derivatives Used For Hedge Accounting Purposes
(Accounting Hedges)
For accounting hedges, the Corporation formally documents at
inception all relationships between hedging instruments and
hedged items, as well as the risk management objectives and
strategies for undertaking various accounting hedges. Additionally,
the Corporation primarily uses regression analysis at the inception
of a hedge and for each reporting period thereafter to assess
whether the derivative used in a hedging transaction is expected
to be and has been highly effective in offsetting changes in the
fair value or cash flows of a hedged item. The Corporation
discontinues 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 accounting hedges 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 attributable to interest rate or foreign exchange volatility.
Cash flow hedges are used primarily to minimize the variability in
cash flows of assets or liabilities, or forecasted transactions
caused by interest rate or foreign exchange fluctuations. For
terminated cash flow hedges, the maximum length of time over
which forecasted transactions are hedged is approximately 25
years, with a substantial portion of the hedged transactions being
less than 10 years. For open or future cash flow hedges, the
maximum length of time over which forecasted transactions are
or will be 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 income statement in which the hedged item is recorded and
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. 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 accumulated OCI are reclassified into earnings in the same
period or periods during which the hedged forecasted transaction
affects earnings. If it is probable that a forecasted transaction will
not occur, any related amounts in accumulated OCI are reclassified
into earnings in that period.
Interest Rate Lock Commitments
The Corporation enters into IRLCs in connection with its mortgage
banking activities to fund residential mortgage loans at specified
times in the future. IRLCs that relate to the origination of mortgage
loans that will be held-for-sale are considered derivative
instruments under applicable accounting guidance. As such, these
IRLCs are recorded at fair value with changes in fair value recorded
in mortgage banking income.
In estimating the fair value of an IRLC, the Corporation assigns
a probability to the loan commitment based on an expectation that
it will be exercised and the loan will be funded. The fair value of
the commitments is derived from the fair value of related mortgage
loans which is based on observable market data and includes the
expected net future cash flows related to servicing of the loans.
Changes to the fair value of IRLCs are recognized based on interest
rate changes, changes in the probability that the commitment will