Derivative Financial Instruments

12 Months Ended

Dec. 31, 2012

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Financial Instruments

Derivative Financial Instruments

The Company has floating rate long-term debt (see Note 12 - Long-Term Debt). Such debt exposes the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense also decreases. The Company uses derivative financial instruments, primarily interest rate swaps, in an attempt to manage its exposure to fluctuations in interest rate movements. The Company’s primary objective in managing interest rate risk is to decrease the volatility of its earnings and cash flows affected by changes in the underlying rates. To achieve this objective, the Company enters into financial derivatives, primarily interest rate swap agreements, the values of which change in the opposite direction of the anticipated future cash flows. The Company does not use derivative financial instruments for speculative purposes.

In March 2007, Level 3 Financing, Inc. entered into two interest rate swap agreements to hedge the interest payments on $1 billion notional amount of floating rate debt. The Company had designated these interest rate swap agreements as cash flow hedges. The two interest rate swap agreements are with different counterparties and are for $500 million each. The arrangements began in April 2007 and mature in January 2014. Under the terms of these arrangements, the Company receives interest payments based on rolling three month LIBOR terms and pays interest at the fixed rate of 4.93% under one arrangement and approximately 4.92% under the other.

Interest Rate Derivative	Number of Instruments	Notional (dollars in millions)
Interest rate swaps	Two	$	1,000

On a quarterly basis, the Company evaluated the effectiveness of the hedges by measuring the extent to which the change in the variable portion of the interest rate swaps offsets the changes in interest expense paid due to fluctuations in the LIBOR-based interest rate. Prior to August 6, 2012, these derivatives were deemed effective cash flow hedges and hedge ineffectiveness was not material in any periods presented. As a result, the change in the fair value of the interest rate swap agreements was reflected in AOCI and was subsequently reclassified into earnings through an interest expense yield adjustment in respect of the hedged debt obligation as periodic settlements occurred throughout the term of the swaps by the making of interest payments on such debt.

As a result of the refinancing of the Tranche A Term Loan on August 6, 2012, the two interest rate swap agreements maturing in early 2014 that had effectively hedged changes in the interest rate on a portion of the Tranche A Term Loan were deemed "ineffective" under GAAP. The Company recognized a non-cash loss on the agreements of approximately $60 million (excluding accrued interest) in the third quarter of 2012, which represented the cumulative loss recorded in AOCI at the date the instruments ceased to qualify as hedges (see Note 12 - Long-Term Debt). After August 6, 2012, the Company will reflect the change in the fair value of the swaps in Other Income in its Consolidated Statement of Operations until maturity of the swaps in early 2014. For the year ended December 31, 2012, the Company recognized a loss of $4 million in Other, net in the Company's Consolidated Statement of Operations.

The Company also issued certain equity conversion rights associated with debt instruments, which were not designated as hedging instruments, but were considered derivative instruments. The Company did not have a remaining liability associated with its equity conversion rights as of December 31, 2012 and 2011. Changes in these derivatives resulted in the Company recognizing no gains for the years ended December 31, 2012 and 2011 and a gain of $10 million for the year ended December 31, 2010.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the consolidated balance sheets as follows (dollars in millions):

	Liability Derivatives
	December 31, 2012			December 31, 2011
Derivatives designated as hedging instruments	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Cash flow hedging contracts	Other noncurrent liabilities	$	—	Other noncurrent liabilities	$	90
	Liability Derivatives
	December 31, 2012			December 31, 2011
Derivatives not designated as hedging instruments	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Interest rate swap agreements	Other noncurrent liabilities	$	56	Other noncurrent liabilities	$	—

The amount of gains (losses) recognized in Other Comprehensive Income (Loss) consists of the following (dollars in millions):

	Year Ended December 31,
Derivatives designated as hedging instruments	2012		2011		2010
Cash flow hedging contracts	$	90	$	18	$	(16	)

The amount of gains (losses) reclassified from AOCI to Income/Loss (effective portions) consists of the following (dollars in millions):

		Year Ended December 31,
Derivatives designated as hedging instruments	Income Statement Location	2012			2011
Cash flow hedging contracts	Interest Expense	$	(26	)	$	(46	)

The effect of the Company’s derivatives not designated as hedging instruments on net loss is as follows (dollars in millions):

Derivatives not designated as hedging instruments	Location of Gain/Loss recognized in Income/Loss on Derivative
		2012			2011		2010
Embedded equity conversion rights	Other Income (Expense)—Other, net	$	—		$	—	$	10
Interest rate swap agreements	Other Income (Expense)—Other, net	(64		)	—		—

The Company is exposed to credit related losses in the event of non-performance by counterparties. The counterparties to the financial derivatives the Company has entered into are major institutions with investment grade credit ratings. The Company evaluates counterparty credit risk before entering into any hedge transaction and continues to closely monitor the financial market and the risk that its counterparties will default on their obligations. This credit risk is generally limited to the unrealized gains in such contracts, should any of these counterparties fail to perform as contracted.