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Derivative Financial Instruments
9 Months Ended
Sep. 30, 2021
Derivative Financial Instruments  
Derivative Financial Instruments

19. Derivative Financial Instruments

The Company uses various derivative financial instruments to mitigate interest rate risk. The Bank’s interest rate risk management strategy involves effectively managing the re-pricing characteristics of certain assets and liabilities to mitigate potential adverse impacts from changes in interest rates on the Bank’s net interest margin. Additionally, the Bank manages variability of cash flows associated with its variable rate debt in interest-related cash outflows with interest rate swap contracts. PrimeLending has interest rate risk relative to interest rate lock commitments (“IRLCs”) and its inventory of mortgage loans held for sale. PrimeLending is exposed to such interest rate risk from the time an IRLC is made to an applicant to the time the related mortgage loan is sold. To mitigate interest rate risk, PrimeLending executes forward commitments to sell mortgage-backed securities (“MBSs”) and Eurodollar futures. Additionally, PrimeLending has interest rate risk relative to its MSR asset and uses derivative instruments, including interest rate swaps and U.S. Treasury bond futures and options to hedge this risk. The Hilltop Broker-Dealers use forward commitments to both purchase and sell MBSs to facilitate customer transactions and as a means to hedge related exposure to interest rate risk in certain inventory positions. Additionally, Hilltop Securities uses various derivative instruments, including U.S. Treasury bond futures and options, Eurodollar futures and municipal market data, or MMD, rate locks, to hedge changes in the fair value of its securities.

Non-Hedging Derivative Instruments and the Fair Value Option

As discussed in Note 4 to the consolidated financial statements, the Company has elected to measure substantially all mortgage loans held for sale at fair value under the provisions of the Fair Value Option. The election provides the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without applying hedge accounting provisions. The fair values of PrimeLending’s IRLCs and forward commitments are recorded in other assets or other liabilities, as appropriate, and changes in the fair values of these derivative instruments are recorded as a component of net gains from sale of loans and other mortgage production income. These changes in fair value are attributable to changes in the volume of IRLCs, mortgage loans held for sale, commitments to purchase and sell MBSs and MSR assets, and changes in market interest rates. Changes in market interest rates also conversely affect the value of PrimeLending’s mortgage loans held for sale and its MSR asset, which are measured at fair value under the Fair Value Option. The effect of the change in market interest rates on PrimeLending’s loans held for sale and MSR asset is discussed in Note 8 to the consolidated financial statements. The fair values of the Hilltop Broker-Dealers’ and the Bank’s derivative instruments are recorded in other assets or other liabilities, as appropriate. Changes in the fair value of derivatives are presented in the following table (in thousands).

Three Months Ended September 30,

Nine Months Ended September 30,

2021

    

2020

    

2021

    

2020

Increase (decrease) in fair value of derivatives during period:

PrimeLending

$

780

$

23,286

$

555

$

90,429

Hilltop Broker-Dealers

11,427

(3,542)

(3,845)

8,466

Bank

7

118

26

(17)

Hedging Derivative Instruments

The Company has entered into interest rate swap contracts to manage the exposure to changes in fair value associated with certain available for sale fixed rate collateralized mortgage backed securities and fixed rate loans held for investment attributable to changes in the designated benchmark interest rate. Certain of these fair value hedges have

been designated as a last-of-layer hedge, which provides the Company the ability to execute a fair value hedge of the interest rate risk associated with a portfolio of similar prepayable assets whereby the last dollar amount estimated to remain in the portfolio of assets is identified as the hedged item. Additionally, the Company has outstanding interest rate swap contracts designated as cash flow hedges and utilized to manage the variability of cash flows associated with its variable rate borrowings.

Under each of its interest rate swap contracts designated as hedges, the Company receives a floating rate and pays a fixed rate on the outstanding notional amount. The Company assesses the hedge effectiveness both at the onset of the hedge and at regular intervals throughout the life of the derivative. To the extent that the derivative instruments are highly effective in offsetting the variability of the hedged cash flows or fair value, changes in the fair value of the derivative are included as a component of other comprehensive loss on our consolidated balance sheets. Although the Company has determined at the onset of the hedges that the derivative instruments will be highly effective hedges throughout the term of the contract, any portion of derivative instruments subsequently determined to be ineffective will be recognized in earnings.

Derivative positions are presented in the following table (in thousands).

September 30, 2021

December 31, 2020

    

Notional

    

Estimated

    

Notional

    

Estimated

Amount

Fair Value

Amount

Fair Value

Derivative instruments (not designated as hedges):

IRLCs

$

2,061,068

$

40,279

$

2,470,013

$

76,048

Commitments to purchase MBSs

 

1,759,435

 

4,745

 

2,478,041

 

22,311

Commitments to sell MBSs

4,646,594

 

14,703

 

6,141,079

 

(40,621)

Interest rate swaps

60,245

 

27

 

43,786

 

(2,196)

U.S. Treasury bond futures and options (1)

215,600

 

 

225,400

 

Eurodollar and other futures (1)

1,182,000

 

 

 

Derivative instruments (designated as hedges):

Interest rate swaps designated as cash flow hedges

$

150,000

$

(812)

$

105,000

$

(3,112)

Interest rate swaps designated as fair value hedges (2)

172,751

3,149

60,618

(130)

(1)Changes in the fair value of these contracts are settled daily with the respective counterparties of PrimeLending and the Hilltop Broker-Dealers.
(2)The Company designated $172.8 million and $60.6 million as the hedged amount (from a closed portfolio of prepayable available for sale securities and loans held for investment with a carrying value of $169.6 million and $60.7 million as of September 30, 2021 and December 31, 2020, respectively), of which, a subset of these hedges are in last-of-layer hedging relationships. The cumulative basis adjustment included in the carrying value of the hedged items totaled $3.2 million and $0.1 million as of September 30, 2021 and December 31, 2020, respectively.

The decrease in the estimated fair value of the IRLCs at September 30, 2021, compared to December 31, 2020, was driven by a decrease in the total volume of IRLCs in addition to a decrease in the average value of individual IRLCs. The decrease in the average value of individual IRLCs was due to an increase in mortgage interest rates throughout the nine months ended September 30, 2021.

PrimeLending held no cash collateral advances, in other liabilities within the consolidated balance sheets, to offset net asset derivative positions on its commitments to sell MBSs at September 30, 2021. PrimeLending had advanced cash collateral totaling $26.1 million to offset net liability positions on its commitments to sell MBSs at December 31, 2020. In addition, PrimeLending and the Hilltop Broker-Dealers had advanced cash collateral totaling $0.7 million and $2.7 million on various derivative instruments at September 30, 2021 and December 31, 2020, respectively. The advanced cash collateral amounts are included in other assets within the consolidated balance sheets.