Note 13. Derivative Instruments and Hedging Activities

Valley is exposed to certain risks arising from both its business operations and economic conditions. Valley principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. Valley manages economic risks, including interest rate and liquidity risks, primarily by managing the amount, sources, and duration of its assets and liabilities and, from time to time, the use of derivative financial instruments. Specifically, Valley enters into derivative financial instruments to manage exposures that arise from business activities that result in the payment of future known and uncertain cash amounts, the value of which are determined by interest rates. Valley’s derivative financial instruments are used to manage differences in the amount, timing, and duration of Valley’s known or expected cash receipts and its known or expected cash payments related to assets and liabilities outlined below.

Cash Flow Hedges of Interest Rate Risk. Valley’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, Valley uses interest rate swaps and caps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the payment of either fixed or variable-rate amounts in exchange for the receipt of variable or fixed-rate amounts from a counterparty. Interest rate caps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium.

At September 30, 2013, Valley had the following cash flow hedge derivatives:

•

Four forward starting interest rate swaps with a total notional amount of $300 million to hedge the changes in cash flows associated with certain prime-rate-indexed deposits, consisting of consumer and commercial money market deposit accounts. Two of the four swaps, totaling $200 million, expire in October 2016 and require Valley to pay fixed-rate amounts at approximately 4.73 percent, in exchange for the receipt of variable-rate payments at the prime rate. Starting in July 2012, the other two swaps totaling $100 million require the payment by Valley of fixed-rate amounts at approximately 5.11 percent in exchange for the receipt of variable-rate payments at the prime rate and expire in July 2017.

•

Two interest rate caps with a total notional amount of $100 million, strike rates of 6.00 percent and 6.25 percent, and a maturity date of July 15, 2015 used to hedge the total change in cash flows associated with prime-rate-indexed deposits, consisting of consumer and commercial money market deposit accounts, which have variable interest rates indexed to the prime rate.

•

One interest rate cap with a total notional amount of $125 million with a strike rate of 7.44 percent and a maturity date of September 27, 2023 used to hedge the total change in cash flows associated with prime-rate indexed deposits, consisting of consumer and commercial money market deposit accounts, which have variable interest rates indexed to the prime rate.

•

Three forward starting interest rate swaps with a total notional amount of $300 million to hedge the changes in cash flows associated with certain FHLB advances within long-term borrowings. Starting in November 2015, the interest rate swaps will require Valley to pay fixed-rate amounts ranging from approximately 2.57 to 2.97 percent, in exchange for the receipt of variable-rate payments at the three-month LIBOR rate. The three swaps have expiration dates ranging from November 2018 to November 2020.

During the third quarter of 2013, Valley entered into a $65 million forward-settle interest rate swap to protect Valley against adverse fluctuations in interest rates by reducing its exposure to variability in cash flows related to interest payments on its subordinated notes issuance in September 2013. The forward-settle swap was cash settled to coincide with date of the subordinated note issuance. The change in fair value of the forward-settle swaps totaling $1.0 million was recorded in accumulated other comprehensive loss at September 30, 2013 and will be amortized into interest expense over the life of the debt.

Fair Value Hedges of Fixed Rate Assets and Liabilities. Valley is exposed to changes in the fair value of certain of its fixed rate assets or liabilities due to changes in benchmark interest rates based on one-month LIBOR. From time to time, Valley uses interest rate swaps to manage its exposure to changes in fair value. Interest rate swaps designated as fair value hedges involve the receipt of variable rate payments from a counterparty in exchange for Valley making fixed rate payments over the life of the agreements without the exchange of the underlying notional amount.

At September 30, 2013, Valley had the following fair value hedge derivatives:

•

One interest rate swap with a notional amount of approximately $8.6 million used to hedge the change in the fair value of a commercial loan.

•

One interest rate swap with a notional amount of $51.0 million, maturing in March 2014, used to hedge the change in the fair value of certain fixed-rate brokered certificates of deposit.

•

One interest rate swap transaction with a notional amount of $125 million, maturing in September 2023, used to hedge the change in the fair value of Valley’s 5.125 percent subordinated notes issued in September 2013.

For derivatives that are designated and qualify as fair value hedges, the gain or loss on the derivative as well as the loss or gain on the hedged item attributable to the hedged risk are recognized in earnings. Valley includes the gain or loss on the hedged items in the same income statement line item as the loss or gain on the related derivatives.

Non-designated Hedges. Derivatives not designated as hedges may be used to manage Valley’s exposure to interest rate movements or to provide service to customers but do not meet the requirements for hedge accounting under U.S. GAAP. Derivatives not designated as hedges are not entered into for speculative purposes. Under a program, Valley executes interest rate swaps with commercial lending customers to facilitate their respective risk management strategies. These interest rate swaps with customers are simultaneously offset by interest rate swaps that Valley executes with a third party, such that Valley minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings. As of September 30, 2013, Valley had a total of 49 interest rate swaps with an aggregate notional amount of $255.4 million related to this program.

Valley also regularly enters into mortgage banking derivatives which are non-designated hedges. These derivatives include interest rate lock commitments provided to customers to fund certain residential mortgage loans to be sold into the secondary market and forward commitments for the future delivery of such loans. Valley enters into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future changes in interest rates on Valley’s commitments to fund the loans as well as on its portfolio of mortgage loans held for sale. As of September 30, 2013, Valley had mortgage banking derivatives with an aggregate notional amount of $22.8 million.

Amounts included in the consolidated statements of financial condition related to the fair value of Valley’s derivative financial instruments were as follows:


		Fair Value
	Balance Sheet Line Item	September 30, 2013		December 31, 2012
		(in thousands)
Asset Derivatives:

Derivatives designated as hedging instruments:
Cash flow hedge interest rate caps and swaps	Other Assets	$	5,718	$	23
Fair value hedge interest rate swaps	Other Assets		270		652


Total derivatives designated as hedging instruments		$	5,988	$	675


Derivatives not designated as hedging instruments:
Interest rate swaps	Other Assets	$	5,548	$	7,002
Mortgage banking derivatives	Other Assets		123		239

Total derivatives not designated as hedging instruments		$	5,671	$	7,241

Liability Derivatives:

Derivatives designated as hedging instruments:
Cash flow hedge interest rate caps and swaps	Other Liabilities	$	13,687	$	17,198
Fair value hedge interest rate swaps	Other Liabilities		1,654		2,197

Total derivatives designated as hedging instruments		$	15,341	$	19,395


Derivatives not designated as hedging instruments:
Interest rate swaps	Other Liabilities	$	5,548	$	6,999
Mortgage banking derivatives	Other Liabilities		207		200

Total derivatives not designated as hedging instruments		$	5,755	$	7,199

Losses included in the consolidated statements of income and in other comprehensive income, on a pre-tax basis, related to interest rate derivatives designated as hedges of cash flows were as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)

Amount of loss reclassified from accumulated other comprehensive loss to interest expense	$	(1,637	)	$	(1,788	)	$	(5,231	)	$	(4,578	)
Amount of loss recognized in other comprehensive income		(4,818	)		(2,101	)		(1,443	)		(5,840	)

Valley recognized net gains of $73 thousand in other expense for hedge ineffectiveness on the cash flow hedge derivatives for the nine months ended September 30, 2012. There were no net gains or losses related to cash flow hedge ineffectiveness recognized during the three and nine months ended September 30, 2013 and the third quarter of 2012. The accumulated net after-tax losses related to effective cash flow hedges included in accumulated other comprehensive loss were $9.9 million and $12.7 million at September 30, 2013 and December 31, 2012, respectively.

Amounts reported in accumulated other comprehensive loss related to cash flow interest rate derivatives are reclassified to interest expense as interest payments are made on the hedged variable interest rate liabilities. Valley estimates that $8.4 million will be reclassified as an increase to interest expense over the next twelve months.

Gains (losses) included in the consolidated statements of income related to interest rate derivatives designated as hedges of fair value were as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
	(in thousands)

Derivative - interest rate swaps:
Interest income	$	22		$	(57	)	$	544		$	(178	)
Interest expense		(108	)		(33	)		(382	)		(60	)

Hedged item - loans, deposits, and long-term borrowings:
Interest income	$	(22	)	$	57		$	(544	)	$	178
Interest expense		101			39			380			77

During the three months ended September 30, 2013 and 2012, the amounts recognized in non-interest expense related to ineffectiveness of fair value hedges were immaterial. Valley also recognized a net reduction to interest expense of $183 thousand and $141 thousand for the three months ended September 30, 2013 and 2012, respectively, and $470 thousand and $416 thousand for the nine months ended September 30, 2013 and 2012, respectively, related to Valley’s fair value hedges on brokered time deposits and subordinated notes, which include net settlements on the derivatives.

The net (losses) gains included in the consolidated statements of income related to derivative instruments not designated as hedging instruments for the three and nine months ended September 30, 2013 and 2012 were as follows:


	Three Months Ended September 30,					Nine Months Ended September 30,
	2013			2012		2013			2012
	(in thousands)
Non-designated hedge interest rate derivatives
Other non-interest expense	$	(1,216	)	$	682	$	(126	)	$	899

Credit Risk Related Contingent Features. By using derivatives, Valley is exposed to credit risk if counterparties to the derivative contracts do not perform as expected. Management attempts to minimize counterparty credit risk through credit approvals, limits, monitoring procedures and obtaining collateral where appropriate. Credit risk exposure associated with derivative contracts is managed at Valley in conjunction with Valley’s consolidated counterparty risk management process. Valley’s counterparties and the risk limits monitored by management are periodically reviewed and approved by the Board of Directors.

Valley has agreements with its derivative counterparties providing that if Valley defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then Valley could also be declared in default on its derivative counterparty agreements. Additionally, Valley has an agreement with several of its derivative counterparties that contains provisions that require Valley’s debt to maintain an investment grade credit rating from each of the major credit rating agencies, from which it receives a credit rating. If Valley’s credit rating is reduced below investment grade or such rating is withdrawn or suspended, then the counterparty could terminate the derivative positions, and Valley would be required to settle its obligations under the agreements. As of September 30, 2013, Valley was in compliance with all of the provisions of its derivative counterparty agreements.

As of September 30, 2013, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $13.9 million. Valley has derivative counterparty agreements that require minimum collateral posting thresholds for certain counterparties. No collateral has been assigned or posted by Valley’s counterparties under the agreements at September 30, 2013. At September 30, 2013, Valley had $31.7 million in collateral posted with its counterparties.