DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

We record all derivatives on the balance sheet at fair value. Note 9 discusses the process to estimate fair value for derivatives. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge 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. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives used to manage the exposure to credit risk, which can include total return swaps, are considered credit derivatives. When put in place after purchase of the asset(s) to be protected, these derivatives generally may not be designated as accounting hedges. See discussion following regarding the total return swap and estimation of its fair value.

For derivatives designated as fair value hedges, changes in the fair value of the derivative are recognized in earnings together with changes in the fair value of the related hedged item. The net amount, if any, representing hedge ineffectiveness, is reflected in earnings. In previous periods, we used fair value hedges to manage interest rate exposure to certain long-term debt. These hedges have been terminated and their remaining balances are being amortized into earnings, as discussed subsequently.

For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative are recorded in OCI and recognized in earnings when the hedged transaction affects earnings. The ineffective portion of changes in the fair value of cash flow hedges is recognized directly in earnings.

No derivatives have been designated for hedges of investments in foreign operations.

We assess the effectiveness of each hedging relationship by comparing the changes in fair value or cash flows on the derivative hedging instrument with the changes in fair value or cash flows on the designated hedged item or transaction. For derivatives not designated as accounting hedges, changes in fair value are recognized in earnings.

Our objectives in using derivatives are to add stability to interest income or expense, to modify the duration of specific assets or liabilities as we consider advisable, to manage exposure to interest rate movements or other identified risks, and/or to directly offset derivatives sold to our customers. To accomplish these objectives, we use interest rate swaps as part of our cash flow hedging strategy. These derivatives are used to hedge the variable cash flows associated with designated commercial loans.

Exposure to credit risk arises from the possibility of nonperformance by counterparties. These counterparties primarily consist of financial institutions that are well established and well capitalized. We control this credit risk through credit approvals, limits, pledges of collateral, and monitoring procedures. No losses on derivative instruments have occurred as a result of counterparty nonperformance. Nevertheless, the related credit risk is considered and measured when and where appropriate.

Our derivative contracts require us to pledge collateral for derivatives that are in a net liability position at a given balance sheet date. Certain of these derivative contracts contain credit-risk-related contingent features that include the requirement to maintain a minimum debt credit rating. We may be required to pledge additional collateral if a credit-risk-related feature were triggered, such as a downgrade of our credit rating. However, in past situations, not all counterparties have demanded that additional collateral be pledged when provided for under their contracts. At September 30, 2012, the fair value of our derivative liabilities was $96.4 million, for which we were required to pledge cash collateral of approximately $104.6 million in the normal course of business. If our credit rating were downgraded by one notch at September 30, 2012, the additional amount of collateral we could be required to pledge is $1 million.

Interest rate swap agreements designated as cash flow hedges involve the receipt of fixed-rate amounts in exchange for variable-rate payments over the life of the agreements without exchange of the underlying principal amount. Derivatives not designated as accounting hedges, including basis swap agreements, are not speculative and are used to economically manage our exposure to interest rate movements and other identified risks, but do not meet the strict hedge accounting requirements.

Selected information with respect to notional amounts and recorded gross fair values at September 30, 2012 and December 31, 2011, and the related gain (loss) of derivative instruments for the three and nine months ended September 30, 2012 and 2011 is summarized as follows:



	September 30, 2012						December 31, 2011
	Notional amount		Fair value				Notional amount		Fair value
(In thousands)	Notional amount		Other assets		Other liabilities		Notional amount		Other assets		Other liabilities
Derivatives designated as hedging instruments
Asset derivatives
Cash flow hedges ¹:
Interest rate swaps	$	150,000	$	2,447	$	—	$	335,000	$	7,341	$	—
Total derivatives designated as hedging instruments	150,000		2,447		—		335,000		7,341		—
Derivatives not designated as hedging instruments
Interest rate swaps	98,524		1,260		1,267		145,388		1,952		1,977
Interest rate swaps for customers ²	2,467,198		84,938		90,074		2,638,601		82,648		87,363
Basis swaps	—		—		—		85,000		3		11
Options contracts	—		—		—		1,700,000		11		—
Total return swap	1,159,686		—		5,048		1,159,686		—		5,422
Total derivatives not designated as hedging instruments	3,725,408		86,198		96,389		5,728,675		84,614		94,773
Total derivatives	$	3,875,408	$	88,645	$	96,389	$	6,063,675	$	91,955	$	94,773



	Three Months Ended September 30, 2012									Nine Months Ended September 30, 2012
	Amount of derivative gain (loss) recognized/reclassified
(In thousands)	OCI		Reclassified from AOCI to interest income		Noninterest income (expense)			Offset to interest expense		OCI		Reclassified from AOCI to interest income			Noninterest income (expense)			Offset to interest expense
Derivatives designated as hedging instruments
Asset derivatives
Cash flow hedges ¹:
Interest rate swaps	$	84	$	2,378	$	—				$	390	$	10,871		$	—
	84		2,378		—					390		10,871		³	—
Liability derivatives
Fair value hedges:
Terminated swaps on long-term debt								$	771									$	2,277
Total derivatives designated as hedging instruments	84		2,378		—			771		390		10,871			—			2,277
Derivatives not designated as hedging instruments
Interest rate swaps					(174		)								(302		)
Interest rate swaps for customers ²					1,331										1,917
Basis swaps					—										18
Futures contracts					(2		)								(12		)
Total return swap					(5,403		)								(16,303		)
Total derivatives not designated as hedging instruments					(4,248		)								(14,682		)
Total derivatives	$	84	$	2,378	$	(4,248	)	$	771	$	390	$	10,871		$	(14,682	)	$	2,277



	Three Months Ended September 30, 2011									Nine Months Ended September 30, 2011
	Amount of derivative gain (loss) recognized/reclassified
(In thousands)	OCI		Reclassified from AOCI to interest income		Noninterest income (expense)			Offset to interest expense		OCI		Reclassified from AOCI to interest income			Noninterest income (expense)			Offset to interest expense
Derivatives designated as hedging instruments
Asset derivatives
Cash flow hedges ¹:
Interest rate swaps	$	585	$	7,471	$	—				$	2,077	$	28,890		$	—
Interest rate floors	38		264		—					221		1,950			—
	623		7,735		—					2,298		30,840		³	—
Liability derivatives
Fair value hedges:
Terminated swaps on long-term debt								$	747									$	2,198
Total derivatives designated as hedging instruments	623		7,735		—			747		2,298		30,840			—			2,198
Derivatives not designated as hedging instruments
Interest rate swaps					181										105
Interest rate swaps for customers ²					(514		)								813
Energy commodity swaps for customers ²					—										56
Basis swaps					4										153
Futures contracts					2,030										6,808
Options contracts					(519		)								(17		)
Total return swap					(5,337		)								(5,337		)
Total derivatives not designated as hedging instruments					(4,155		)								2,581
Total derivatives	$	623	$	7,735	$	(4,155	)	$	747	$	2,298	$	30,840		$	2,581		$	2,198

Note: These tables are not intended to present at any given time the Company’s long/short position with respect to its derivative contracts.

¹Amounts recognized in OCI and reclassified from accumulated OCI (“AOCI”) represent the effective portion of the derivative gain (loss).

²Amounts include both the customer swaps and the offsetting derivative contracts.

³Amounts for the nine months ended September 30, 2012 and 2011 of $10.9 million and $30.8 million, respectively, are the amounts of reclassification to earnings presented in the tabular changes of AOCI in Note 7.

At September 30, the fair values of derivative assets and liabilities were reduced (increased) by net credit valuation adjustments of $5.2 million and $0.1 million in 2012, and $5.4 million and $(0.3) million in 2011, respectively. These adjustments are required to reflect both our own nonperformance risk and the respective counterparty’s nonperformance risk.

Under master netting arrangements, we offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against recognized fair value amounts of derivatives executed with the same counterparty.

We offer to our customers interest rate swaps to assist them in managing their exposure to fluctuating interest rates. Previously, we also offered energy commodity swaps. Upon issuance, all of these customer swaps are immediately “hedged” by offsetting derivative contracts, such that the Company minimizes its net risk exposure resulting from such transactions. Fee income from customer swaps is included in other service charges, commissions and fees. As with other derivative instruments, we have credit risk for any nonperformance by counterparties.

Options contracts were used to economically hedge certain interest rate exposures of previously used Eurodollar futures contracts. All of these contracts expired during the first quarter of 2012.

The remaining balances of any derivative instruments terminated prior to maturity, including amounts in AOCI for swap hedges, are accreted or amortized to interest income or expense over the period to their previously stated maturity dates.

Amounts in AOCI are reclassified to interest income as interest is earned on variable rate loans and as amounts for terminated hedges are accreted or amortized to earnings. For the 12 months following September 30, 2012, we estimate that an additional $5 million will be reclassified.

Total Return Swap

On July 28, 2010, we entered into a total return swap and related interest rate swaps (“TRS”) with Deutsche Bank AG (“DB”) relating to a portfolio of $1.16 billion notional amount of our bank and insurance trust preferred CDOs. As a result of the TRS, DB assumed all of the credit risk of this CDO portfolio, providing timely payment of all scheduled payments of interest and principal when contractually due to the Company (without regard to acceleration or deferral events). The transaction reduced regulatory risk-weighted assets and improved the Company’s risk-based capital ratios.

The transaction did not qualify for hedge accounting and did not change the accounting for the underlying securities, including the quarterly analysis of OTTI and OCI. As a result, future potential OTTI, if any, associated with the underlying securities may not be offset by any valuation adjustment on the swap in the quarter in which OTTI is recognized, and OTTI changes could result in reductions in our regulatory capital ratios, which could be material.

The fair value of the TRS derivative liability was $5.0 million at September 30, 2012 and $5.4 million at December 31, 2011.

Both the fair values of the securities and the fair value of the TRS are dependent upon the projected credit-adjusted cash flows of the securities. The period that we are unable to cancel the transaction has shortened to and will remain at one calendar quarter. Accordingly, absent major changes in these projected cash flows, we expect the value of the TRS liability to continue to approximate its September 30, 2012 fair value. We expect to incur subsequent net quarterly costs of approximately $5.4 million under the TRS, including related interest rate swaps and scheduled payments of interest on the underlying CDOs, as long as the TRS remains in place for this CDO portfolio. Our estimated quarterly expense amount would be impacted by, among other things, changes in the composition of the CDO portfolio included in the transaction and changes over time in the forward London Interbank Offered Rate (“LIBOR”) rate curve. The Company’s costs are also subject to adjustment in the event of future changes in regulatory requirements applicable to DB if we do not then elect to terminate the transaction. Termination by the Company for such regulatory changes applicable to DB will result in no payment by the Company.

At September 30, 2012, we completed a valuation process which resulted in an estimated fair value for the TRS under Level 3. The process utilized valuation inputs from two sources:

The Company built on its fair valuation process for the underlying CDO portfolio and utilized those same projected cash flows to quantify the extent and timing of payments to be received from the Trustee related to each CDO and in the aggregate. For valuation purposes, we assumed that a market participant would cancel the TRS at the first opportunity if the TRS did not have a positive value based on the best estimates of cash flows through maturity. Consequently, the fair value approximated the amount of required payments up to the earliest termination date.


2)	A valuation from a market participant in possession of all relevant terms and costs of the TRS structure.

We considered the observable input or inputs from the market participant, who is the counterparty to this transaction, as well as the results of our internal modeling in estimating the fair value of the TRS. We expect to continue the use of this methodology in subsequent periods.