Derivatives and Hedging Activities
 3 Months Ended
Mar. 31, 2015
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivatives and Hedging Activities
Derivatives and Hedging Activities
The Company uses derivatives to manage its exposure to various financial risks. The Company does not enter into derivatives for trading or speculative purposes. Certain derivatives used to manage the Company’s exposure to interest rate movements and other identified risks are not designated as hedges and do not qualify for hedge accounting.
Derivatives may give rise to counterparty credit risk, which generally is addressed through collateral arrangements as described under the sub-heading "— Collateral Requirements and Credit-Risk Related Contingency Features." The Company enters into derivative transactions with established dealers that meet minimum credit criteria established by the Company. All counterparties must be pre-approved prior to engaging in any transaction with the Company. Counterparties are monitored on a regular basis by the Company to ensure compliance with the Company’s risk policies and limits. In determining the counterparty credit risk valuation adjustment for the fair values of derivatives, the Company considers collateral and legally enforceable master netting agreements that mitigate credit exposure to related counterparties.
All derivatives are recorded in other assets at their gross positive fair values and in accrued expenses and other liabilities at their gross negative fair values. See Note 13: Fair Value Measurements and Disclosures for a description of the valuation methodologies of derivatives. Cash collateral posted and held balances are recorded in other assets and deposits, respectively, in the condensed consolidated statements of financial condition. Collateral amounts recorded in the condensed consolidated statements of financial condition are based on the net collateral posted or held position for each applicable legal entity's master netting arrangement with each counterparty.
Derivatives Designated as Hedges
Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows arising from changes in interest rates, or other types of forecasted transactions, are considered cash flow hedges. Derivatives designated and qualifying as a hedge of the exposure to fluctuations in foreign exchange rates on investments in foreign entities are referred to as net investment hedges. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges.
Cash Flow Hedges
The Company uses interest rate swaps to manage its exposure to changes in interest rates related to future cash flows resulting from interest payments on credit card securitized debt and deposits, and previously from interest receipts on credit card loan receivables. The Company's outstanding cash flow hedges are for an initial maximum period of five years for securitized debt and seven years for deposits. The derivatives are designated as hedges of the risk of changes in cash flows on the Company's LIBOR or Federal Funds rate-based interest payments and qualify for hedge accounting in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”).
The effective portion of the change in the fair value of derivatives designated as cash flow hedges is recorded in OCI and is subsequently reclassified into earnings in the period that the hedged forecasted cash flows affect earnings. The ineffective portion of the change in fair value of the derivative, if any, is recognized directly in earnings. Amounts reported in AOCI related to derivatives at March 31, 2015 will be reclassified to interest expense as interest payments are made on certain of the Company's floating-rate securitized debt or deposits. During the next 12 months, the Company estimates it will reclassify $40 million of pretax losses to interest expense related to its derivatives designated as cash flow hedges.
Net Investment Hedges
The Company is exposed to fluctuations in foreign exchange rates on investments it holds in foreign entities with a functional currency other than the U.S. dollar. The Company uses foreign exchange forward contracts to hedge its exposure to changes in foreign exchange rates on its net investment in Diners Club Italy. Foreign exchange forward contracts utilized by the Company involve fixing the U.S. dollar-euro exchange rate for delivery of a specified amount of foreign currency on a specified date. These derivatives are designated as net investment hedges, with the effective portion of changes in the fair value of the derivatives reported in OCI as part of the cumulative translation adjustment. The ineffective portion of the change in fair value of the derivatives, if any, is recognized directly in earnings. Amounts are reclassified out of AOCI into earnings when the hedged net investment is either sold or substantially liquidated.
Fair Value Hedges
The Company is exposed to changes in fair value of certain of its fixed-rate debt obligations due to changes in interest rates. The Company uses interest rate swaps to manage its exposure to changes in fair value of certain fixed-rate senior notes, securitized debt and interest-bearing brokered deposits attributable to changes in LIBOR, a benchmark interest rate as defined by ASC 815. These interest rate swaps qualify as fair value hedges in accordance with ASC 815. Changes in both (i) the fair values of the derivatives and (ii) the hedged fixed-rate senior notes, securitized debt and interest-bearing brokered deposits relating to the risk being hedged are recorded in interest expense. The changes generally provide substantial offset to one another, with any difference, or ineffectiveness recorded in interest expense. Any basis differences between the fair value and the carrying amount of the hedged item at the inception of the hedging relationship are amortized to interest expense.
Derivatives Not Designated as Hedges
Interest Rate Swaps
The Company may have, from time to time, interest rate swap agreements that are not designated as hedges. As part of its acquisition of SLC, the Company also acquired an interest rate swap related to the securitized debt assumed in the transaction. Such agreements are not speculative and are also used to manage interest rate risk but are not designated for hedge accounting. Changes in the fair value of these contracts are recorded in other income.
Foreign Exchange Forward Contracts
The Company has foreign exchange forward contracts that are economic hedges and are not designated as accounting hedges. The Company enters into foreign exchange forward contracts to manage foreign currency risk. Changes in the fair value of these contracts are recorded in other income.
Forward Delivery Contracts
The Company economically hedges the changes in fair value of IRLCs and mortgage loans held for sale caused by changes in interest rates by using TBA MBS and entering into best-efforts forward delivery commitments. These derivative instruments are recorded at fair value with changes in fair value recorded in other income.
Interest Rate Lock Commitments
The Company enters into commitments with consumers to originate residential mortgage loans at a specified interest rate. The Company reports IRLCs that relate to the origination of mortgage loans that will be held for sale as derivative instruments at fair value with changes in fair value recorded in other income.
The following table summarizes the fair value (including accrued interest) and outstanding notional amounts of derivative instruments and related collateral balances (dollars in millions):
 
March 31, 2015
 
December 31, 2014
 
Notional
Amount
 
Number of Outstanding Derivative Contracts
 
Derivative Assets
 
Derivative Liabilities
 
Notional
Amount
 
Derivative Assets
 
Derivative Liabilities
Derivatives designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate swaps—cash flow hedge
$
4,100

 
8

 
$
—

 
$
50

 
$
4,100

 
$
4

 
$
18

Interest rate swaps—fair value hedge
$
4,237

 
162

 
39

 
—

 
$
5,507

 
31

 
2

Foreign exchange forward contract - net investment hedge(1)
$
2

 
1

 
—

 
—

 
$
7

 
—

 
—

Derivatives not designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange forward contracts(2)
$
36

 
7

 
—

 
—

 
$
53

 
—

 
—

Interest rate swap(3)
$
277

 
1

 
—

 
—

 
$
359

 
—

 
—

Forward delivery contracts
$
1,477

 
416

 
4

 
5

 
$
761

 
1

 
3

Interest rate lock commitments(3)
$
689

 
2,785

 
14

 
—

 
$
406

 
7

 
—

Total gross derivative assets / liabilities(4)
 
 
 
 
57

 
55

 
 
 
43

 
23

Less: Collateral held/posted(5)
 
 
 
 
(26
)
 
(51
)
 
 
 
(20
)
 
(23
)
Total net derivative assets / liabilities
 
 
 
 
$
31

 
$
4

 
 
 
$
23

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
The foreign exchange forward contract has a notional amount of EUR 2 million and EUR 6 million as of March 31, 2015 and December 31, 2014, respectively.
(2)
The foreign exchange forward contracts have notional amounts of EUR 23 million, GBP 6 million and SGD 1 million as of March 31, 2015 and EUR 27 million, GBP 8 million, SGD 1 million and CHF 8 million as of December 31, 2014.
(3)
Interest rate swaps not designated as hedges and interest rate lock commitments do not have associated master netting arrangements.
(4)
In addition to the derivatives disclosed in the table, the Company enters into forward contracts to purchase when-issued mortgage-backed securities as part of its community reinvestment initiatives. At March 31, 2015, the Company had one outstanding contract with a notional amount of $17 million and immaterial fair value. At December 31, 2014, the Company had one outstanding contract with a notional amount of $33 million and immaterial fair value.
(5)
Collateral amounts, which consist of both cash and investment securities, are limited to the related derivative asset/liability balance and do not include excess collateral received/pledged.
The following tables summarize the impact of the derivative instruments on income and OCI and indicates where within the condensed consolidated financial statements such impact is reported (dollars in millions):
 
 
 
Amount of Loss
Recognized in OCI
 
 
 
For the Three Months Ended March 31,
 
Location
 
2015
 
2014
Derivatives designated as hedges:
 
 
 
 
 
Interest rate swaps - cash flow/net investment hedges:
 
 
 
 
 
Total loss recognized in OCI after amounts reclassified into earnings, pre-tax
OCI
 
$
(35
)
 
$
(6
)
Total loss recognized in OCI
 
 
$
(35
)
 
$
(6
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amount of (Loss) Gain Recognized in Income
 
 
 
For the Three Months Ended March 31,
 
Location
 
2015
 
2014
Derivatives designated as hedges:
 
 
 
 
 
Interest rate swaps - cash flow hedges:
 
 
 
 
 
Amount reclassified from OCI into income
Interest Income
 
$
—

 
$
—

Amount reclassified from OCI into income
Interest Expense
 
(12
)
 
(7
)
Total amount reclassified from OCI into income
 
 
(12
)

(7
)
 
 
 
 
 
 
Interest rate swaps - fair value hedges:
 
 
 
 
 
Adjustments - ineffectiveness
 
 
5

 
(2
)
Adjustments - other
 
 
8

 
10

Gain on interest rate swaps
Interest Expense
 
13

 
8

 
 
 
 
 
 
Adjustments - ineffectiveness
 
 
(3
)
 
3

Adjustments - other
 
 
(1
)
 
3

(Loss) gain on hedged item
Interest Expense
 
(4
)
 
6

 
 
 
 
 
 
Total (loss) gain recognized in income
 
 
$
(3
)

$
7

 
 
 
 
 
 
Derivatives not designated as hedges:
 
 
 
 
 
Gain on forward contracts
Other Income
 
$
3

 
$
—

Loss on interest rate swaps
Other Income
 
—

 
(1
)
Gain (loss) on forward delivery contracts
Other Income
 
2

 
(3
)
Gain on interest rate lock commitments
Other Income
 
44

 
18

Total gain on derivatives not designated as hedges recognized in income
 
 
$
49

 
$
14

 
 
 
 
 
 

Collateral Requirements and Credit-Risk Related Contingency Features
The Company has master netting arrangements and minimum collateral posting thresholds with its counterparties for its fair value and cash flow hedge interest rate swaps, foreign exchange forward contracts and forward delivery contracts. The Company has not sought a legal opinion in relation to the enforceability of its master netting arrangements and, as such, does not report any of these positions on a net basis. Collateral is required by either the Company or its subsidiaries or the counterparty depending on the net fair value position of these derivatives held with that counterparty. The Company may also be required to post collateral with a counterparty for its fair value and cash flow hedge interest rate swaps depending on the credit rating it or Discover Bank receives from specified major credit rating agencies. Collateral receivable or payable amounts are not offset against the fair value of these derivatives, but are recorded separately in other assets or deposits.
As of March 31, 2015, DFS had a right to reclaim $4 million of cash collateral that had been posted (net of amounts required to be posted by the counterparty) because the credit rating of the Company did not meet specified thresholds. At March 31, 2015, Discover Bank’s credit rating met specified thresholds set by its counterparties. However, if its credit rating is reduced by one ratings notch, Discover Bank would be required to post additional collateral, which would have been $94 million as of March 31, 2015.
The Company also has agreements with certain of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.