Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions

9 Months Ended

Sep. 30, 2012

Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions

Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions

Note 13 – Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions

To meet the financing needs of its customers, the Bank, as a subsidiary of the Company, is a party to various financial instruments with off-balance-sheet risk in the normal course of business.  These off-balance-sheet financial instruments include commitments to originate and sell loans as well as financial standby, performance standby and commercial letters of credit.  The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.  The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and letters of credit are represented by the dollar amount of those instruments.  Management generally uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Interest Rate Swaps

The Company also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments.  These derivative positions relate to transactions in which the Bank enters into an interest rate swap with a client while at the same time entering into an offsetting interest rate swap with another financial institution.  Due to financial covenant violations relating to nonperforming loans, the Bank had $5.1 million in investment securities pledged to support interest rate swap activity with two correspondent financial institutions at September 30, 2012.  The Bank had $5.2 million in investment securities pledged to support interest rate swap activity with a correspondent financial institution at December 31, 2011.  In connection with each transaction, the Bank agrees to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate.  At the same time, the Bank agrees to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount.  The transaction allows the client to effectively convert a variable rate loan to a fixed rate loan and is also part of the Company’s interest rate risk management strategy.  Because the Bank acts as an intermediary for the client, changes in the fair value of the underlying derivative contracts offset each other and do not generally impact the results of operations.  Fair value measurements include an assessment of credit risk related to the client’s ability to perform on their contract position, however, and valuation estimates related to that exposure are discussed in Note 12 above.  At September 30, 2012, the notional amount of non-hedging interest rate swaps was $114.7 million with a weighted average maturity of 1.48 years.  At December 31, 2011, the notional amount of non-hedging interest rate swaps was $117.8 million with a weighted average maturity of 2.24 years.  The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.

The Bank also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards.  The interest rate risk associated with these loan interest rate lock commitments is managed by entering into contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts.  Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward mortgage – backed securities contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking income.  Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.

The following table presents derivatives not designated as hedging instruments as of September 30, 2012:

			Asset Derivatives			Liability Derivatives
	Notional or Contractual Amount		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Interest rate swap contracts net of credit valuation	$	114,693	Other Assets	$	2,238	Other Liabilities	$	2,299
Commitments1	255,438		Other Assets	550		N/A	-
Forward contracts2	44,500		N/A	-		Other Liabilities	-
Total				$	2,788		$	2,299

1 Includes unused loan commitments, interest rate lock commitments, forward rate lock, and mortgage-backed securities commitments.

2  Includes forward mortgage – backed securities contracts and forward loan contracts.

The following table presents derivatives not designated as hedging instruments as of December 31, 2011:

			Asset Derivatives			Liability Derivatives
	Notional or Contractual Amount		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Interest rate swap contracts net of credit valuation	$	117,756	Other Assets	$	3,072	Other Liabilities	$	3,152
Commitments1	237,970		Other Assets	107		N/A	-
Forward contracts2	26,000		N/A	-		Other Liabilities	50
Total				$	3,179		$	3,202

1 Includes unused loan commitments, interest rate lock commitments and forward rate lock and mortgage-backed securities commitments.

2  Includes forward mortgage – backed securities contracts and forward loan contracts.

The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party.  The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to our customers.

In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO.  The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2012, and December 31, 2011.

	September 30, 2012		December 31, 2011
Commitments to extend credit: borrowers
Financial standby letters of credit	$	3,400	$	2,837
Performance standby letters of credit	6,522		8,554
Commercial letters of credit	51		375
Total letters of credit: borrowers	9,973		11,766
Commitments to extend credit: other
Financial standby letters of credit	550		550
Performance standby letters of credit	1,229		2,324
Commercial letters of credit	-		-
Total letters of credit: other	1,779		2,874
Total letters of credit
Financial standby letters of credit	3,950		3,387
Performance standby letters of credit	7,751		10,878
Commercial letters of credit	51		375
Total letters of credit	$	11,752	$	14,640