NOTE 7: DERIVATIVES

The use of derivative instruments allows First Financial to meet the needs of its clients while managing the interest-rate risk associated with certain transactions. First Financial’s board of directors has authorized the use of certain derivative products, including interest rate caps, floors and swaps. First Financial does not use derivatives for speculative purposes and currently does not have any derivatives that are not designated as hedges.

The following table summarizes the derivative financial instruments utilized by First Financial by the nature of the underlying asset or liability:




(Dollars in thousands)	September 30, 2012		December 31, 2011
Fair value hedges
Instruments associated with loans
Total notional value	$	903,252	$	775,328

Cash flow hedges
Instruments associated with deposits
Total notional value	35,000		0
Total	$	938,252	$	775,328

While authorized to use a variety of derivative products, First Financial primarily utilizes interest rate swaps as a means to offer borrowers credit-based products that meet their needs and may from time to time utilize interest rate swaps to manage the macro interest rate risk profile of the Company. These agreements establish the notional amount, or basis on which interest rate payments are exchanged with counterparties.

As only interest rate payments are exchanged, cash requirements and credit risk are significantly less than the notional amount and the Company’s credit risk exposure is limited to the market value of the instrument. First Financial manages this market value credit risk through borrower and counterparty credit policies. First Financial's counterparty credit policies require the Company to maintain a total derivative notional position of less than 35% of assets, total credit exposure of less than 3% of capital and no single counterparty credit risk exposure greater than $20.0 million. The Company is currently well below all single counterparty and portfolio limits. At September 30, 2012, the Company had a total counterparty notional amount outstanding of approximately $493.6 million, spread among eight counterparties, with an outstanding liability from these contracts of $28.6 million. At December 31, 2011, the Company had a total counterparty notional amount outstanding of approximately $396.4 million, spread among seven counterparties, with an outstanding liability from these contracts of $27.3 million.

First Financial’s exposure to credit loss, in the event of nonperformance by a borrower, is limited to the market value of the derivative instrument associated with that borrower. First Financial monitors its derivative credit exposure to borrowers by monitoring the creditworthiness of the related loan customers through the normal credit review processes the Company performs on all borrowers. Additionally, the Company monitors derivative credit risk exposure related to problem loans through the Company's allowance for loan and lease losses committee. First Financial considers the market value of a derivative instrument to be part of the carrying value of the related loan for these purposes as the borrower is contractually obligated to pay First Financial this amount in the event the derivative contract is terminated.

In connection with its use of derivative instruments, First Financial from time to time is required to post cash collateral with its counterparties to offset its market position. Derivative collateral balances were $25.4 million and $24.4 million at September 30, 2012, and December 31, 2011, respectively. First Financial classifies the derivative cash collateral outstanding with its counterparties as an adjustment to the fair value of the derivative contracts within accrued interest and other liabilities in the Consolidated Balance Sheets.

The following table summarizes the derivative financial instruments utilized by First Financial and their balances:



		September 30, 2012							December 31, 2011
				Estimated fair value							Estimated fair value
(Dollars in thousands)	Balance Sheet Classification	Notional amount		Gain		Loss			Notional amount		Gain		Loss
Fair value hedges
Pay fixed interest rate swaps with counterparty	Accrued interest and other liabilities	$	13,850	$	0	$	(1,594	)	$	17,456	$	0	$	(2,263	)
Matched interest rate swaps with borrower	Accrued interest and other assets	444,701		26,198		0			378,936		24,566		0
Matched interest rate swaps with counterparty	Accrued interest and other liabilities	444,701		0		(27,430		)	378,936		0		(25,860		)
Cash flow hedges
Pay fixed interest rate swaps with counterparty	Accrued interest and other liabilities	$	35,000	$	0	$	(292	)	0		0		0
Total		$	938,252	$	26,198	$	(29,316	)	$	775,328	$	24,566	$	(28,123	)

The following table details the derivative financial instruments, the average remaining maturities and the weighted-average interest rates being paid and received by First Financial at September 30, 2012:



							Weighted-average rate
(Dollars in thousands)	Notional amount		Average maturity (years)	Fair value			Receive		Pay
Asset conversion swaps
Pay fixed interest rate swaps with counterparty	$	13,850	3.6	$	(1,594	)	2.35	%	6.81	%
Receive fixed, matched interest rate swaps with borrower	444,701		4.5	26,198			5.22	%	2.97	%
Pay fixed, matched interest rate swaps with counterparty	444,701		4.5	(27,430		)	2.97	%	5.22	%
Total asset conversion swaps	$	903,252	4.4	$	(2,826	)	4.07	%	4.13	%

Liability conversion swaps
Pay fixed interest rate swaps with counterparty	$	35,000	6.8	$	(292	)	3.25	%	4.02	%
Total liability conversion swaps	$	35,000	6.8	$	(292	)	3.25	%	4.02	%
Total swap portfolio	$	938,252	4.5	$	(3,118	)	4.04	%	4.13	%

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.

Fair Value Hedges. First Financial utilizes interest rate swaps as a means to offer commercial borrowers products that meet their needs, but are also designed to achieve First Financial’s desired interest rate risk profile at the time. The fair value hedge agreements generally involve the net receipt by First Financial of floating-rate amounts in exchange for net payments by First Financial, through its loan clients, of fixed-rate amounts over the life of the agreements without an exchange of the underlying principal or notional amount. This results in First Financial’s loan customers receiving fixed rate funding, while providing First Financial with a floating rate asset. The net interest receivable or payable on the interest rate swaps is accrued and recognized as an adjustment to the interest income or interest expense of the hedged item. The fair value of the interest rate swaps is included within accrued interest and other assets on the Consolidated Balance Sheets. The corresponding fair-value adjustment is also included on the Consolidated Balance Sheets in the carrying value of the hedged item. Derivative gains and losses not considered effective in hedging the change in fair value of the hedged item, if any, are recognized in income immediately.

The following table details the location and amounts recognized for fair value hedges:



		Decrease to Interest income
(Dollars in thousands)		Three months ended						Nine months ended
Derivatives in fair value hedging relationships	Classification of change in fair value	September 30,						September 30,
		2012			2011			2012			2011
Interest rate contracts
Loans	Interest income - loans	$	(167	)	$	(221	)	$	(555	)	$	(692	)
Total		$	(167	)	$	(221	)	$	(555	)	$	(692	)

Cash Flow Hedges. First Financial utilizes interest rate swaps designated as cash flow hedges to manage the variability of cash flows, primarily net interest income, attributable to changes in interest rates. The net interest receivable or payable on an interest rate swap designated as a cash flow hedge is accrued and recognized as an adjustment to interest income or interest expense. The fair value of interest rate swaps is included within accrued interest and other liabilities on the Consolidated Balance Sheets. Changes in the fair value of interest rate swaps are included in accumulated comprehensive income (loss). Derivative gains and losses not considered effective in hedging the cash flows related to the hedged items, if any, are recognized in income immediately.

Effective July 2, 2012, First Financial executed a cash flow hedge utilizing an interest rate swap to hedge against interest rate volatility on $35.0 million of floating rate interest-bearing deposits indexed to the U.S. Federal Funds Target Rate. This interest rate swap involves the receipt by First Financial of variable-rate interest amounts in exchange for fixed-rate interest payments by First Financial for a period of 7 years.

The following table details the location and amounts recognized for cash flow hedges:



	Amount of gain/(loss) recognized in OCI on derivatives (effective portion)							Amount of gain/(loss) reclassified from accumulated OCI into earnings (effective portion)
(Dollars in thousands)	September 30, 2012							September 30, 2012
Derivatives in cash flow hedging relationships	Three months ended			Nine months ended			Classification of change in fair value	Three months ended			Nine months ended
Interest rate contracts
Interest-bearing deposits	$	(182	)	$	(182	)	Interest income-interest-bearing deposits	$	(67	)	$	(67	)
Total	$	(182	)	$	(182	)		$	(67	)	$	(67	)