2004 Annual Report: Financial Review: Statements and Notes: Note 4 Derivatives

Note 4

Derivatives

The Corporation designates a derivative as held for trading or hedging purposes when it enters into the derivative contract. The designation may change based upon management’s reassessment or changing circumstances. Derivatives utilized by the Corporation include swaps, financial futures and forward settlement contracts, and option contracts. A swap agreement is a contract between two parties to 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 instrument (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 manage the credit risk associated with the loan portfolio.

Credit Risk Associated with Derivative Activities

Credit risk associated with derivatives is measured as the net replacement cost in the event the counterparties with contracts in a gain position to the Corporation completely fail to perform under the terms of those contracts. In managing derivative credit risk, both the current exposure, which is the replacement cost of contracts on the measurement date, as well as an estimate of the potential change in value of contracts over their remaining lives are considered. The Corporation’s derivative activities are primarily with financial institutions and corporations. To minimize credit risk, the Corporation enters into legally enforceable master netting agreements, which reduce risk by permitting the closeout and netting of transactions with the same counterparty upon occurrence of certain events. In addition, the Corporation reduces credit risk by obtaining collateral from counterparties. The determination of the need for and the levels of collateral will vary based on an assessment of the credit risk of the counterparty. Generally, the Corporation accepts collateral in the form of cash, U.S. Treasury securities and other marketable securities. The Corporation held $26.9 billion of collateral on derivative positions, of which $16.8 billion could be applied against credit risk at December 31, 2004.

A portion of the derivative activity involves exchange-traded instruments. Exchange-traded instruments conform to standard terms and are subject to policies set by the exchange involved, including margin and security deposit requirements. Management believes the credit risk associated with these types of instruments is minimal.

The following table presents the contract/notional and credit risk amounts at December 31, 2004 and 2003 of the Corporation’s derivative positions held for trading and hedging purposes. These derivative positions are primarily executed in the over-the-counter market. The credit risk amounts take into consideration the effects of legally enforceable master netting agreements, and on an aggregate basis have been reduced by the cash collateral held against Derivative Assets. At December 31, 2004 and 2003, the cash collateral held against Derivative Assets on the Consolidated Balance Sheet was $9.4 billion and $7.5 billion, respectively. In addition, at December 31, 2004 and 2003, the cash collateral placed against Derivative Liabilities was $6.0 billion and $9.5 billion, respectively.

Derivatives (1)
	December 31, 2004: Contract/Notional	December 31, 2004: Credit Risk	December 31, 2003: Contract/Notional	December 31, 2003: Credit Risk		FleetBoston April 1, 2004: Contract/Notional	FleetBoston April 1, 2004: Credit Risk
	December 31					FleetBoston April 1, 2004
	2004		2003
(Dollars in millions)	Contract/ Notional	Credit Risk	Contract/ Notional	Credit Risk		Contract/ Notional	Credit Risk
Interest rate contracts
Swaps	$11,597,813	$12,705	$8,873,600	$14,893		$105,366	$1,671
Futures and forwards	1,833,216	332	2,437,907	633		18,383	2
Written options	988,253	-	1,174,014	-		104,118	-
Purchased options	1,243,809	4,840	1,132,486	3,471		159,408	91
Foreign exchange contracts
Swaps	305,999	7,859	260,210	4,473		9,928	307
Spot, futures and forwards	956,995	3,593	775,105	4,202		33,941	403
Written options	167,225	-	138,474	-		2,854	-
Purchased options	163,243	679	133,512	669		2,776	58
Equity contracts
Swaps	34,130	1,039	30,850	364		1,026	127
Futures and forwards	4,078	-	3,234	-		-	-
Written options	37,080	-	25,794	-		779	-
Purchased options	32,893	5,741	24,119	5,370		811	55
Commodity contracts
Swaps	10,480	2,099	15,491	1,554		-	-
Futures and forwards	6,307	6	5,726	-		275	-
Written options	9,270	-	11,695	-		-	-
Purchased options	5,535	301	7,223	294		-	-
Credit derivatives	499,741	430	136,788	584		29,763	75
Credit risk before cash collateral		39,624		36,507			2,789
Less: Cash collateral held		9,389		7,498			96
Total derivative assets		$30,235		$29,009			$2,693
(1) Includes both long and short derivative positions.

The average fair value of Derivative Assets for 2004 and 2003 was $28.0 billion and $27.8 billion, respectively. The average fair value of Derivative Liabilities for 2004 and 2003 was $15.7 billion and $15.9 billion, respectively. Included in the average fair value of Derivative Assets and Derivative Liabilities in 2004 was $1.5 billion and $920 million, respectively, from the addition of derivatives acquired from FleetBoston.

ALM Process

Interest rate contracts and foreign exchange contracts are utilized in the Corporation’s ALM process. The Corporation maintains an overall interest rate risk management strategy that incorporates the use of interest rate contracts to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. The Corporation’s goal is to manage interest rate sensitivity so that movements in interest rates do not significantly adversely affect Net Interest Income. As a result of interest rate fluctuations, hedged fixed-rate assets and liabilities appreciate or depreciate in market value. Gains or losses on the derivative instruments that are linked to the hedged fixed-rate assets and liabilities are expected to substantially offset this unrealized appreciation or depreciation. Interest Income and Interest Expense on hedged variable-rate assets and liabilities, respectively, increase or decrease as a result of interest rate fluctuations. Gains and losses on the derivative instruments that are linked to these hedged assets and liabilities are expected to substantially offset this variability in earnings.

Interest rate contracts, which are generally non-leveraged generic interest rate and basis swaps, options and futures, allow the Corporation to manage its interest rate risk position. Non-leveraged generic interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments based on the contractual underlying notional amount. Basis swaps involve the exchange of interest payments based on the contractual underlying notional amounts, where both the pay rate and the receive rate are floating rates based on different indices. Option products primarily consist of caps, floors, swaptions and options on index futures contracts. Futures contracts used for the ALM process are primarily index futures providing for cash payments based upon the movements of an underlying rate index.

The Corporation uses foreign currency contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities, as well as the Corporation’s equity investments in foreign subsidiaries. Foreign exchange contracts, which include spot, futures and forward contracts, represent agreements to exchange the currency of one country for the currency of another country at an agreed-upon price on an agreed-upon settlement date. Foreign exchange option contracts are similar to interest rate option contracts except that they are based on currencies rather than interest rates. Exposure to loss on these contracts will increase or decrease over their respective lives as currency exchange and interest rates fluctuate.

Fair Value and Cash Flow Hedges

The Corporation uses various types of interest rate and foreign currency exchange rate derivative contracts to protect against changes in the fair value of its fixed-rate assets and liabilities due to fluctuations in interest rates and exchange rates. The Corporation also uses these contracts to protect against changes in the cash flows of its variable-rate assets and liabilities, and other forecasted transactions.

For cash flow hedges, gains and losses on derivative contracts reclassified from Accumulated OCI to current period earnings are included in the line item in the Consolidated Statement of Income in which the hedged item is recorded and in the same period the hedged item affects earnings. During the next 12 months, net losses on derivative instruments included in Accumulated OCI, of approximately $136 million (pre-tax) are expected to be reclassified into earnings. These net gains reclassified into earnings are expected to increase income or decrease expense on the respective hedged items.

The following table summarizes certain information related to the Corporation’s hedging activities for 2004 and 2003.

(Dollars in millions)	2004	2003
Fair value hedges
Hedge ineffectiveness recognized in earnings (1)	$  10	$   -
Net loss excluded from assessment of effectiveness (2)	(6)	(101)
Cash flow hedges
Hedge ineffectiveness recognized in earnings (3)	104	53
Net gain excluded from assessment of effectiveness	-	26
Net investment hedges
Gains (losses) included in foreign currency translation adjustments   within accumulated other comprehensive income	(157)	(194)
(1) Included $(8) recorded in Net Interest Income and $18 recorded in Mortgage Banking Income in the Consolidated Statement of Income in 2004. (2) Included $(5) and $(101), respectively, recorded in Net Interest Income related to the excluded time value of certain hedges and $(1) and $0, respectively, recorded in Mortgage Banking Income in the Consolidated Statement of Income in 2004 and 2003. (3) Included $117 and $38, respectively, recorded in Mortgage Banking Income in the Consolidated Statement of Income for 2004 and 2003, and $(13) and $15 recorded in Net Interest Income from other various cash flow hedges in 2004 and 2003, respectively.