Financial Derivatives

12 Months Ended

Dec. 31, 2011

Financial Derivatives

Financial Derivatives

Note 14. Financial Derivatives

As part of managing interest rate risk, the Bank has entered into interest rate swap agreements as vehicles to partially hedge cash flows associated with interest expense on variable rate deposit accounts. Under the swap agreements, the Bank receives a variable rate and pays a fixed rate. Such agreements are generally entered into with counterparties that meet established credit standards and most contain collateral provisions protecting the at-risk party. The Bank considers the credit risk inherent in these contracts to be negligible. Interest rate swap agreements derive their value from underlying interest rates. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations, payments, and the value of the derivative are based. The notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Such difference, which represents the fair value of the swap, is reflected on the Corporation's balance sheet.

The Corporation is exposed to credit-related losses in the event of nonperformance by the counterparty to these agreements. The Corporation controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures, and does not expect the counterparty to fail its obligations.

The primary focus of the Corporation's asset/liability management program is to monitor the sensitivity of the Corporation's net portfolio value and net income under varying interest rate scenarios to take steps to control its risks. On a quarterly basis, the Corporation simulates the net portfolio value and net interest income expected to be earned over a twelve-month period following the date of simulation. The simulation is based upon projection of market interest rates at varying levels and estimates the impact of such market rates on the levels of interest-earning assets and interest-bearing liabilities during the measurement period. Based upon the outcome of the simulation analysis, the Corporation considers the use of derivatives as a means of reducing the volatility of net portfolio value and projected net income within certain ranges of projected changes in interest rates. The Corporation evaluates the effectiveness of entering into any derivative instrument agreement by measuring the cost of such an agreement in relation to the reduction in net portfolio value and net income volatility within an assumed range of interest rates.

During 2008, the Bank entered into two swap transactions. Each swap has a notional amount of $10 million with one maturing in 2013 and one in 2015. According to the terms of each transaction, the Bank pays fixed-rate interest payments and receives floating-rate payments. The swaps were entered into to hedge the Corporation's exposure to changes in cash flows attributable to the effect of interest rate changes on variable-rate liabilities. At December 31, 2011, the fair value of the swaps was negative $1.7 million and was recognized in accumulated other comprehensive loss, net of tax.

The Board of Directors has given Management authorization to enter into additional derivative activity including interest rate swaps, caps and floors, forward-rate agreements, options and futures contracts in order to hedge interest rate risk. The Bank is exposed to credit risk equal to the positive fair value of a derivative instrument, if any, as a positive fair value indicates that the counterparty to the agreement is financially liable to the Bank. To limit this risk, counterparties must have an investment grade long-term debt rating and individual counterparty credit exposure is limited by Board approved parameters. Management anticipates continuing to use derivatives, as permitted by its Board-approved policy, to manage interest rate risk.

Information regarding the interest rate swaps as of December 31, 2011 follows:

			Interest Rate				Amount Expected to be Expensed into Earnings within the next 12 Months
(Dollars in thousands) Notional Amount	Maturity Date		Fixed		Variable
$10,000		5/30/2013		3.60%		0.03%	$	358
$10,000		5/30/2015		3.87%		0.03%	$	385

The variable rate is indexed to the 91-day Treasury Bill auction (discount) rate and resets weekly.

Fair Value of Derivative Instruments in the Consolidated Balance Sheets were as follows as of December 31, 2011:

Fair Value of Derivative Instruments
(Dollars in thousands) Date	Type		Balance Sheet Location		Fair Value
December 31, 2011		Interest rate contracts		Other liabilities	$	1,738
December 31, 2010		Interest rate contracts		Other liabilities	$	1,752

The Effect of Derivative Instruments on the Statement of Income for the years ended December 31, 2011, 2010 and 2009 follows:

Derivatives in ASC Topic 815 Cash Flow Hedging Relationships
(Dollars in thousands) Date / Type	Amount of Gain or (Loss) Recognized in OCI net of tax on Derivative (Effective Portion)			Location of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)		Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)			Location of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)		Amount of Gain or (Loss) Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing)
December 31, 2011
Interest rate contracts	$	8			Interest Expense	$	(727)			Other income (expense)	$	—
December 31, 2010
Interest rate contracts	$	(322	)		Interest Expense	$	(718	)		Other income (expense)	$	—
December 31, 2009
Interest rate contracts	$	801			Interest Expense	$	(716	)		Other income (expense)	$	—