10. Derivative Financial Instruments

The Bancorp maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce certain risks related to interest rate, prepayment and foreign currency volatility. Additionally, the Bancorp holds derivative instruments for the benefit of its commercial customers. The Bancorp does not enter into unhedged speculative derivative positions.

The Bancorp’s interest rate risk management strategy involves modifying the repricing characteristics of certain financial instruments so that changes in interest rates do not adversely affect the Bancorp’s net interest margin and cash flows. Derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, options and swaptions. Interest rate swap contracts are exchanges of interest payments, such as fixed-rate payments for floating-rate payments, based on a common notional amount and maturity date. Interest rate floors protect against declining rates, while interest rate caps protect against rising interest rates. Forward contracts are contracts in which the buyer agrees to purchase, and the seller agrees to make delivery of, a specific financial instrument at a predetermined price or yield. Options provide the purchaser with the right, but not the obligation, to purchase or sell a contracted item during a specified period at an agreed upon price. Swaptions are financial instruments granting the owner the right, but not the obligation, to enter into or cancel a swap.

Prepayment volatility arises mostly from changes in fair value of the largely fixed-rate MSR portfolio, mortgage loans and mortgage-backed securities. The Bancorp may enter into various free-standing derivatives (principal-only swaps, swaptions, floors, options and interest rate swaps) to economically hedge prepayment volatility. Principal-only swaps are total return swaps based on changes in the value of the underlying mortgage principal-only trust.

Foreign currency volatility occurs as the Bancorp enters into certain loans denominated in foreign currencies. Derivative instruments that the Bancorp may use to economically hedge these foreign denominated loans include foreign exchange swaps and forward contracts.

The Bancorp also enters into derivative contracts (including foreign exchange contracts, commodity contracts and interest rate swaps, floors and caps) for the benefit of commercial customers and other business purposes. The Bancorp may economically hedge significant exposures related to these free-standing derivatives by entering into offsetting third-party contracts with approved, reputable counterparties with substantially matching terms and currencies. Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Bancorp’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. Credit risk is minimized through credit approvals, limits, counterparty collateral and monitoring procedures.

The Bancorp’s derivative assets contain certain contracts in which the Bancorp requires the counterparties to provide collateral in the form of cash and securities to offset changes in the fair value of the derivatives, including changes in the fair value due to credit risk of the counterparty. As of June 30, 2011, December 31, 2010 and June 30, 2010, the balance of collateral held by the Bancorp for derivative assets was $989 million, $903 million and $975 million, respectively. The credit component negatively impacting the fair value of derivative assets associated with customer accommodation contracts as of June 30, 2011, December 31, 2010 and June 30, 2010, was $30 million, $41 million and $50 million, respectively.

In measuring the fair value of derivative liabilities, the Bancorp considers its own credit risk, taking into consideration collateral maintenance requirements of certain derivative counterparties and the duration of instruments with counterparties that do not require collateral maintenance. The Bancorp’s derivative liabilities consist primarily of contracts that require collateral to be maintained in the form of cash and securities to offset changes in fair value of the derivatives, including changes in fair value due to the Bancorp’s credit risk. As of June 30, 2011, December 31, 2010 and June 30, 2010, the balance of collateral posted by the Bancorp for derivative liabilities was $646 million, $680 million and $903 million, respectively. Certain of the Bancorp’s derivative liabilities contain credit-risk related contingent features that could result in the requirement to post additional collateral upon the occurrence of specified events. As of June 30, 2011, the fair value of the additional collateral that could be required to be posted as a result of the credit-risk related contingent features being triggered was not material to the Bancorp’s Condensed Consolidated Financial Statements. The posting of collateral has been determined to remove the need for consideration of credit risk. As a result, the Bancorp determined that the impact of the Bancorp’s credit risk to the valuation of its derivative liabilities was immaterial to the Bancorp’s Condensed Consolidated Financial Statements.

The Bancorp holds certain derivative instruments that qualify for hedge accounting treatment and are designated as either fair value hedges or cash flow hedges. Derivative instruments that do not qualify for hedge accounting treatment, or for which hedge accounting is not established, are held as free-standing derivatives and provide the Bancorp an economic hedge. All customer accommodation derivatives are held as free-standing derivatives.

The fair value of derivative instruments is presented on a gross basis, even when the derivative instruments are subject to master netting arrangements. Derivative instruments with a positive fair value are reported in other assets in the Condensed Consolidated Balance Sheets while derivative instruments with a negative fair value are reported in other liabilities in the Condensed Consolidated Balance Sheets. Cash collateral payables and receivables associated with the derivative instruments are not added to or netted against the fair value amounts.

The following tables reflect the notional amounts and fair values for all derivative instruments included in the Condensed Consolidated Balance Sheets as of:

Fair Value

June 30, 2011 ($ in millions)

Notional
Amount

Derivative
Assets

Derivative
Liabilities

Qualifying hedging instruments

Fair value hedges:

Interest rate swaps related to long-term debt

4,080

422

—

Interest rate swaps related to time deposits

—

Total fair value hedges

422

—

Cash flow hedges:

Interest rate floors related to C&I loans

1,500

128

—

Interest rate swaps related to C&I loans

2,000

Interest rate caps related to long-term debt

1,500

—

Interest rate swaps related to long-term debt

250

—

Total cash flow hedges

171

Total derivatives designated as qualifying hedging instruments

593

Derivatives not designated as qualifying hedging instruments

Free-standing derivatives—risk management and other business purposes

Interest rate contracts related to MSRs

16,452

196

Forward contracts related to held for sale mortgage loans

2,210

Interest rate swaps related to long-term debt

373

Foreign exchange contracts for trading purposes

1,681

Put options associated with Processing Business Sale

901

—

Stock warrants associated with Processing Business Sale

205

104

—

Swap associated with the sale of Visa, Inc. Class B shares

416

—

Total free-standing derivatives—risk management and other business purposes

310

Free-standing derivatives—customer accommodation:

Interest rate contracts for customers

28,607

675

700

Interest rate lock commitments

1,729

Commodity contracts

1,939

Foreign exchange contracts

20,848

293

281

Derivative instruments related to equity linked CDs

Total free-standing derivatives—customer accommodation

1,061

1,063

Total derivatives not designated as qualifying hedging instruments

1,371

1,130

Total

1,964

1,157


			Fair Value
December 31, 2010 ($ in millions)	Notional Amount		Derivative Assets		Derivative Liabilities
Qualifying hedging instruments
Fair value hedges:
Interest rate swaps related to long-term debt	$	4,355		442		—
Interest rate swaps related to time deposits		—		—		—

Total fair value hedges				442		—

Cash flow hedges:
Interest rate floors related to C&I loans		1,500		153		—
Interest rate swaps related to C&I loans		3,000		8		—
Interest rate caps related to long-term debt		1,500		4		—
Interest rate swaps related to long-term debt		1,190		—		31

Total cash flow hedges				165		31

Total derivatives designated as qualifying hedging instruments				607		31

Derivatives not designated as qualifying hedging instruments
Free-standing derivatives—risk management and other business purposes
Interest rate contracts related to MSRs		12,477		141		81
Forward contracts related to held for sale mortgage loans		6,389		90		14
Interest rate swaps related to long-term debt		173		3		1
Foreign exchange contracts for trading purposes		2,494		4		4
Put options associated with Processing Business Sale		769		—		8
Stock warrants associated with Processing Business Sale		175		79		—
Swap associated with the sale of Visa, Inc. Class B shares		363		—		18

Total free-standing derivatives—risk management and other business purposes				317		126

Free-standing derivatives—customer accommodation:
Interest rate contracts for customers		26,817		701		735
Interest rate lock commitments		1,772		9		9
Commodity contracts		1,878		99		92
Foreign exchange contracts		17,998		339		319
Derivative instruments related to equity linked CDs		70		2		2

Total free-standing derivatives—customer accommodation				1,150		1,157

Total derivatives not designated as qualifying hedging instruments				1,467		1,283

Total			$	2,074		1,314


			Fair Value
June 30, 2010 ($ in millions)	Notional Amount		Derivative Assets		Derivative Liabilities
Qualifying hedging instruments
Fair value hedges:
Interest rate swaps related to long-term debt	$	4,355		559		—
Interest rate swaps related to time deposits		296		—		1

Total fair value hedges				559		1

Cash flow hedges:
Interest rate floors related to C&I loans		1,500		171		—
Interest rate swaps related to C&I loans		3,500		26		10
Interest rate caps related to long-term debt		2,500		13		—
Interest rate swaps related to long-term debt		907		—		20

Total cash flow hedges				210		30

Total derivatives designated as qualifying hedging instruments				769		31

Derivatives not designated as qualifying hedging instruments
Free-standing derivatives—risk management and other business purposes
Interest rate contracts related to MSRs		7,557		236		7
Forward contracts related to held for sale mortgage loans		2,707		—		50
Interest rate swaps related to long-term debt		304		4		1
Foreign exchange contracts for trading purposes		6,919		37		37
Put options associated with Processing Business Sale		759		—		9
Stock warrants associated with Processing Business Sale		173		82		—
Swap associated with the sale of Visa, Inc. Class B shares		397		—		43

Total free-standing derivatives—risk management and other business purposes				359		147

Free-standing derivatives—customer accommodation:
Interest rate contracts for customers		26,890		828		870
Interest rate lock commitments		2,416		22		1
Commodity contracts		1,203		81		72
Foreign exchange contracts		13,453		270		245
Derivative instruments related to equity linked CDs		113		2		2

Total free-standing derivatives—customer accommodation				1,203		1,190

Total derivatives not designated as qualifying hedging instruments				1,562		1,337

Total			$	2,331		1,368

Fair Value Hedges

The Bancorp may enter into interest rate swaps to convert its fixed-rate, long-term debt or time deposits to floating-rate. Decisions to convert fixed-rate debt or time deposits to floating are made primarily through consideration of the asset/liability mix of the Bancorp, the desired asset/liability sensitivity and interest rate levels. As of June 30, 2011, December 31, 2010 and June 30, 2010, certain interest rate swaps met the criteria required to qualify for the shortcut method of accounting. Based on this shortcut method of accounting treatment, no ineffectiveness is assumed. For interest rate swaps that do not meet the shortcut requirements, an assessment of hedge effectiveness using regression analysis was performed and such swaps were accounted for using the “long-haul” method. The long-haul method requires a quarterly assessment of hedge effectiveness and measurement of ineffectiveness. For interest rate swaps accounted for as a fair value hedge using the long-haul method, ineffectiveness is the difference between the changes in the fair value of the interest rate swap and changes in fair value of the long-term debt attributable to the risk being hedged. The ineffectiveness on interest rate swaps hedging long-term debt or time deposits is reported within interest expense in the Condensed Consolidated Statements of Income.

The following table reflects the change in fair value of interest rate contracts, designated as fair value hedges, as well as the change in fair value of the related hedged items attributable to the risk being hedged, included in the Condensed Consolidated Statements of Income:


	Condensed Consolidated	For the three months ended June 30,						For the six months ended June 30,
($ in millions)	Statements of Income Caption	2011			2010			2011			2010
Interest rate contracts:
Change in fair value of interest rate swaps hedging long-term debt	Interest on long-term debt	$	46			220			(20	)		285
Change in fair value of hedged long-term debt	Interest on long-term debt		(52	)		(220	)		13			(287	)
Change in fair value of interest rate swaps hedging time deposits	Interest on deposits		—			2			—			5
Change in fair value of hedged time deposits	Interest on deposits		—			(2	)		—			(5	)

Cash Flow Hedges

The Bancorp may enter into interest rate swaps to convert floating-rate assets and liabilities to fixed rates or to hedge certain forecasted transactions. The assets or liabilities are typically grouped and share the same risk exposure for which they are being hedged. The Bancorp may also enter into interest rate caps and floors to limit cash flow variability of floating rate assets and liabilities. As of June 30, 2011, all hedges designated as cash flow hedges are assessed for effectiveness using regression analysis. Ineffectiveness is generally measured as the amount by which the cumulative change in the fair value of the hedging instrument exceeds the present value of the cumulative change in the hedged item’s expected cash flows. Ineffectiveness is reported within other noninterest income in the Condensed Consolidated Statements of Income. The effective portion of the gains or losses on cash flow hedges are reported within accumulated other comprehensive income and are reclassified from accumulated other comprehensive income to current period earnings when the forecasted transaction affects earnings. As of June 30, 2011, the maximum length of time over which the Bancorp is hedging its exposure to the variability in future cash flows related to the forecasted issuance of floating rate debt is 21 months.

Reclassified gains and losses on interest rate floors and swaps related to commercial loans are recorded within interest income while reclassified gains and losses on interest rate caps and swaps related to debt are recorded within interest expense in the Condensed Consolidated Statements of Income. As of June 30, 2011, December 31, 2010 and June 30, 2010, $68 million, $67 million and $85 million, respectively, of deferred gains, net of tax, on cash flow hedges were recorded in accumulated other comprehensive income in the Condensed Consolidated Balance Sheets. As of June 30, 2011, $35 million in net deferred gains, net of tax, recorded in accumulated other comprehensive income are expected to be reclassified into earnings during the next twelve months. During the three and six months ended June 30, 2011 and 2010, there were no gains or losses reclassified into earnings associated with the discontinuance of cash flow hedges because it was probable that the original forecasted transaction would not occur.

The following table presents the net gains (losses) recorded in the Condensed Consolidated Statements of Income and accumulated other comprehensive income in the Condensed Consolidated Statement of Changes in Shareholders’ Equity relating to derivative instruments designated as cash flow hedges.


	For the three months						For the six months
	ended June 30,						ended June 30,
($ in millions)	2011			2010			2011			2010
Amount of loss recognized in OCI	$	(32	)		(3	)		(32	)		(2	)
Amount of gain reclassified from OCI into net interest income		16			18			31			29
Amount of ineffectiveness recognized in other noninterest income		—			(2	)		—			1

Free-Standing Derivative Instruments – Risk Management and Other Business Purposes

As part of its overall risk management strategy relative to its mortgage banking activity, the Bancorp may enter into various free-standing derivatives (principal-only swaps, swaptions, floors, options and interest rate swaps) to economically hedge changes in fair value of its largely fixed-rate MSR portfolio. Principal-only swaps hedge the mortgage-LIBOR spread because these swaps appreciate in value as a result of tightening spreads. Principal-only swaps also provide prepayment protection by increasing in value when prepayment speeds increase, as opposed to MSRs that lose value in a faster prepayment environment. Receive fixed/pay floating interest rate swaps and swaptions increase in value when interest rates do not increase as quickly as expected.

The Bancorp enters into forward contracts to economically hedge the change in fair value of certain residential mortgage loans held for sale due to changes in interest rates. The Bancorp may also enter into forward swaps to economically hedge the change in fair value of certain commercial mortgage loans held for sale due to changes in interest rates. Interest rate lock commitments issued on residential mortgage loan commitments that will be held for sale are also considered free-standing derivative instruments and the interest rate exposure on these commitments is economically hedged primarily with forward contracts. Revaluation gains and losses from free-standing derivatives related to mortgage banking activity are recorded as a component of mortgage banking net revenue in the Condensed Consolidated Statements of Income.

Additionally, the Bancorp may enter into free-standing derivative instruments (options, swaptions and interest rate swaps) in order to minimize significant fluctuations in earnings and cash flows caused by interest rate and prepayment volatility. The gains and losses on these derivative contracts are recorded within other noninterest income in the Condensed Consolidated Statements of Income.

In conjunction with the Processing Business Sale in 2009, the Bancorp received warrants and issued put options, which are accounted for as free-standing derivatives. Refer to Note 19 for further discussion of significant inputs and assumptions used in the valuation of these instruments.

In conjunction with the sale of Visa, Inc. Class B shares in 2009, the Bancorp entered into a total return swap in which the Bancorp will make or receive payments based on subsequent changes in the conversion rate of the Class B shares into Class A shares. This total return swap is accounted for as a free-standing derivative. See Note 19 for further discussion of significant inputs and assumptions used in the valuation of this instrument.

The Bancorp enters into certain derivatives (forwards, futures and options) related to its foreign exchange business. These derivative contracts are not designated against specific assets or liabilities or to forecasted transactions. Therefore, these instruments do not qualify for hedge accounting. The Bancorp economically hedges the exposures related to these derivative contracts by entering into offsetting contracts with approved, reputable, independent counterparties with substantially similar terms. Revaluation gains and losses on these foreign currency derivative contracts are recorded within other noninterest income in the Condensed Consolidated Statements of Income.

The net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for risk management and other business purposes are summarized in the following table:


($ in millions)	Condensed Consolidated Statements of Income Caption	For the three months ended June 30,						For the six months ended June 30,
($ in millions)	Condensed Consolidated Statements of Income Caption	2011			2010			2011			2010
Interest rate contracts:
Forward contracts related to residential mortgage loans held for sale	Mortgage banking net revenue	$	4			(52	)		(79	)		(82	)
Interest rate swaps and swaptions related to MSR portfolio	Mortgage banking net revenue		129			96			102			154
Interest rate swaps related to long-term debt	Other noninterest income		3			1			4			2
Foreign exchange contracts:
Foreign exchange contracts for trading purposes	Other noninterest income		—			2			(1	)		1
Equity contracts:
Warrants associated with Processing Business Sale	Other noninterest income		28			9			25			7
Put options associated with Processing Business Sale	Other noninterest income		2			1			1			1
Swap associated with sale of Visa, Inc. Class B shares	Other noninterest income		(4	)		1			(13	)		(9	)

Free-Standing Derivative Instruments – Customer Accommodation

The majority of the free-standing derivative instruments the Bancorp enters into are for the benefit of its commercial customers. These derivative contracts are not designated against specific assets or liabilities on the Bancorp’s Condensed Consolidated Balance Sheets or to forecasted transactions and, therefore, do not qualify for hedge accounting. These instruments include foreign exchange derivative contracts entered into for the benefit of commercial customers involved in international trade to hedge their exposure to foreign currency fluctuations and commodity contracts to hedge such items as natural gas and various other derivative contracts. The Bancorp may economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms. The Bancorp hedges its interest rate exposure on commercial customer transactions by executing offsetting swap agreements with primary dealers. Revaluation gains and losses on interest rate, foreign exchange, commodity and other commercial customer derivative contracts are recorded as a component of corporate banking revenue in the Condensed Consolidated Statements of Income.

The Bancorp enters into risk participation agreements, under which the Bancorp assumes credit exposure relating to certain underlying interest rate derivative contracts. The Bancorp only enters into these risk participation agreements in instances in which the Bancorp has participated in the loan that the underlying interest rate derivative contract was designed to hedge. The Bancorp will make payments under these agreements if a customer defaults on its obligation to perform under the terms of the underlying interest rate derivative contract. As of June 30, 2011, December 31, 2010 and June 30, 2010, the total notional amount of the risk participation agreements was $723 million, $851 million and $824 million, respectively, and the fair value was a liability of $2 million at June 30, 2011 and $1 million at December 31, 2010 and June 30, 2010, which is included in interest rate contracts for customers. As of June 30, 2011, the risk participation agreements had an average life of 2.0 years.

The Bancorp’s maximum exposure in the risk participation agreements is contingent on the fair value of the underlying interest rate derivative contracts in an asset position at the time of default. The Bancorp monitors the credit risk associated with the underlying customers in the risk participation agreements through the same risk grading system currently utilized for establishing loss reserves in its loan and lease portfolio.

Risk ratings of the notional amount of risk participation agreements under this risk rating system are summarized in the following table:


($ in millions)	June 30, 2011		December 31, 2010		June 30, 2010
Pass	$	645		744		520
Special mention		34		37		225
Substandard		43		69		11
Doubtful		—		1		8
Loss		1		—		60

Total	$	723		851		824

The net gains (losses) recorded in the Condensed Consolidated Statements of Income relating to free-standing derivative instruments used for customer accommodation are summarized in the following table:


($ in millions)	Condensed Consolidated Statements of Income Caption	For the three months ended June 30,						For the six months ended June 30,
($ in millions)	Condensed Consolidated Statements of Income Caption	2011			2010			2011			2010
Interest rate contracts:
Interest rate contracts for customers (contract revenue)	Corporate banking revenue	$	7			5			15			11
Interest rate contracts for customers (credit losses)	Other noninterest expense		(10	)		(5	)		(12	)		(7	)
Interest rate contracts for customers (credit portion of fair value adjustment)	Other noninterest expense		3			(4	)		10			(9	)
Interest rate lock commitments	Mortgage banking net revenue		31			72			55			108
Commodity contracts:
Commodity contracts for customers (contract revenue)	Corporate banking revenue		2			2			3			4
Commodity contracts for customers (credit portion of fair value adjustment)	Other noninterest expense		1			—			1			1
Foreign exchange contracts:
Foreign exchange contracts—customers (contract revenue)	Corporate banking revenue		15			18			31			32
Foreign exchange contracts—customers (credit portion of fair value adjustment)	Other noninterest expense		5			—			1			—