Financial Instruments with Off-Balance Sheet Risk and Derivative Financial Instruments

9 Months Ended

Sep. 30, 2011

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Financial Instruments with Off-Balance Sheet Risk and Derivative Financial Instruments

Financial Instruments with Off-Balance Sheet Risk and Derivative Financial Instruments

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to manage the Corporation’s exposure to fluctuations in interest rates.  These financial instruments include commitments to extend credit, standby letters of credit, equity commitments to affordable housing partnerships, interest rate swap agreements and commitments to originate and commitments to sell fixed rate mortgage loans.  These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Corporation’s Consolidated Balance Sheets.  The contract or notional amounts of these instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments.  The Corporation’s credit policies with respect to interest rate swap agreements with commercial borrowers, commitments to extend credit, and financial guarantees are similar to those used for loans.  The interest rate swaps with other counterparties are generally subject to bilateral collateralization terms.  The contractual and notional amounts of financial instruments with off-balance sheet risk are as follows:

(Dollars in thousands)	Sept. 30, 2011		Dec 31, 2010
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit:
Commercial loans	$	227,309	$	176,436
Home equity lines	182,147		182,260
Other loans	27,821		23,971
Standby letters of credit	8,729		9,510
Equity commitments to affordable housing partnerships	—		449
Financial instruments whose notional amounts exceed the amount of credit risk:
Forward loan commitments:
Commitments to originate fixed rate mortgage loans to be sold	75,863		10,893
Commitments to sell fixed rate mortgage loans	97,705		24,901
Customer related derivative contracts:
Interest rate swaps with customers	61,897		59,749
Mirror swaps with counterparties	61,897		59,749
Interest rate risk management contracts:
Interest rate swap contracts	32,991		32,991

Commitments to Extend Credit

Commitments to extend credit are agreements to lend to a customer as long as there are no violations of any conditions established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Each borrower’s creditworthiness is evaluated on a case-by-case basis.  The amount of collateral obtained is based on management’s credit evaluation of the borrower.

Standby Letters of Credit

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Under a standby letter of credit, the Corporation is required to make payments to the beneficiary of the letter of credit upon request by the beneficiary contingent upon the customer’s failure to perform under the terms of the underlying contract with the beneficiary.  Standby letters of credit extend up to five years.  At September 30, 2011 and December 31, 2010, the maximum potential amount of undiscounted future payments, not reduced by amounts that may be recovered, totaled $8.7 million and $9.5 million, respectively.  At September 30, 2011 and December 31, 2010, there were no liabilities to beneficiaries resulting from standby letters of credit.  Fee income on standby letters of credit for the three and nine months ended September 30, 2011 amounted to $29 thousand and $125 thousand, respectively, compared to $25 thousand and $65 thousand, respectively, for the three and nine months ended September 30, 2010.

At September 30, 2011 and December 31, 2010, a substantial portion of the standby letters of credit was supported by pledged collateral.  The collateral obtained is determined based on management’s credit evaluation of the customer.  Should the Corporation be required to make payments to the beneficiary, repayment from the customer to the Corporation is required.

Equity Commitments

As of September 30, 2011, Washington Trust has investments in two real estate limited partnerships, one of which was entered into in the latter portion of 2010.  The partnerships were created for the purpose of renovating and operating low-income housing projects.  Equity commitments to affordable housing partnerships represented funding commitments by Washington Trust to the limited partnerships.  The funding of commitments was contingent upon substantial completion of the projects.

Forward Loan Commitments

Interest rate lock commitments are extended to borrowers that relate to the origination of readily marketable mortgage loans held for sale.  To mitigate the interest rate risk inherent in these rate locks, as well as closed mortgage loans held for sale, best efforts forward commitments are established to sell individual mortgage loans.  Both interest rate lock commitments and commitments to sell fixed rate residential mortgage loans are derivative financial instruments. Effective July 1, 2011, Washington Trust elected to carry newly originated closed loans held for sale at fair value pursuant to Accounting Standards Codifications ("ASC") Topic No. 825, "Financial Instruments." Changes in fair value of the interest rate lock commitments, commitments to sell fixed rate mortgage loans and loans held for sale are recognized in earnings.

Interest Rate Risk Management Agreements

Interest rate swaps are used from time to time as part of the Corporation’s interest rate risk management strategy.  Swaps are agreements in which the Corporation and another party agree to exchange interest payments (e.g., fixed-rate for variable-rate payments) computed on a notional principal amount.  The credit risk associated with swap transactions is the risk of default by the counterparty.  To minimize this risk, the Corporation enters into interest rate agreements only with highly rated counterparties that management believes to be creditworthy.  The notional amounts of these agreements do not represent amounts exchanged by the parties and, thus, are not a measure of the potential loss exposure.

At of September 30, 2011 and December 31, 2010, the Bancorp had three interest rate swap contracts designated as cash flow hedges to hedge the interest rate associated with $33 million of variable rate junior subordinated debenture.  The effective portion of the changes in fair value of derivatives designated as cash flow hedges is recorded in other comprehensive income and subsequently reclassified to earnings when gains or losses are realized.  The ineffective portion of changes in fair value of the derivatives is recognized directly in earnings as interest expense.  The Bancorp pledged collateral to derivative counterparties in the form of cash totaling $1.9 million as of September 30, 2011 and December 31, 2010.  The Bancorp may need to post additional collateral in the future in proportion to potential increases in unrealized loss positions.

The Bank has entered into interest rate swap contracts to help commercial loan borrowers manage their interest rate risk.  The interest rate swap contracts with commercial loan borrowers allow them to convert floating rate loan payments to fixed rate loan payments.  When we enter into an interest rate swap contract with a commercial loan borrower, we simultaneously enter into a “mirror” swap contract with a third party.  The third party exchanges the client’s fixed rate loan payments for floating rate loan payments.  We retain the risk that is associated with the potential failure of counterparties and inherent in making loans.  At September 30, 2011 and December 31, 2010, Washington Trust had interest rate swap contracts with commercial loan borrowers with notional amounts of $61.9 million and $59.7 million, respectively, and equal amounts of “mirror” swap contracts with third-party financial institutions.  These derivatives are not designated as hedges and therefore, changes in fair value are recognized in earnings.

The following table presents the fair values of derivative instruments in the Corporation’s Consolidated Balance Sheets as of the dates indicated:

(Dollars in thousands)	Asset Derivatives					Liability Derivatives
	Balance Sheet	Fair Value				Balance Sheet	Fair Value
	Location	Sept. 30, 2011		Dec. 31, 2010		Location	Sept. 30, 2011		Dec. 31, 2010
Derivatives Designated as Cash Flow Hedging Instruments:
Interest rate risk management contracts:
Interest rate swap contracts		$	—	$	—	Other liabilities	$	1,950	$	1,098
Derivatives not Designated as Hedging Instruments:
Forward loan commitments:
Commitments to originate fixed rate mortgage loans to be sold	Other assets	2,443		31		Other liabilities	—		135
Commitments to sell fixed rate mortgage loans	Other assets	—		571		Other liabilities	3,271		32
Customer related derivative contracts:
Interest rate swaps with customers	Other assets	4,799		3,690			—		—
Mirror swaps with counterparties		—		—		Other liabilities	4,967		3,806
Total		$	7,242	$	4,292		$	10,188	$	5,071

The following tables present the effect of derivative instruments in the Corporations’ Consolidated Statements of Income and Changes in Shareholders’ Equity for the periods indicated:

(Dollars in thousands)	Gain (Loss) Recognized in Other Comprehensive Income (Effective Portion)				Location of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing)	Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
	Three Months		Nine Months			Three Months		Nine Months
Periods ended Sept. 30,	2011	2010	2011	2010		2011	2010	2011	2010
Derivatives in Cash Flow Hedging Relationships:
Interest rate risk management contracts:
Interest rate swap contracts	$(375)	$(576)	$(549)	$(1,120)	Interest Expense	$—	$—	$—	$(78)
Total	$(375)	$(576)	$(549)	$(1,120)		$—	$—	$—	$(78)

(Dollars in thousands)		Amount of Gain (Loss) Recognized in Income on Derivative
	Location of Gain (Loss) Recognized in	Three Months						Nine Months
Periods ended September 30,	Income on Derivative	2011			2010			2011			2010
Derivatives not Designated as Hedging Instruments:
Forward loan commitments:
Commitments to originate fixed rate mortgage loans to be sold	Net gains on loan sales & commissions on loans originated for others	$	2,514		$	(143	)	$	2,547		$	255
Commitments to sell fixed rate mortgage loans	Net gains on loan sales & commissions on loans originated for others	(3,304		)	122			(3,810		)	(613		)
Customer related derivative contracts:
Interest rate swaps with customers	Net gains (losses) on interest rate swaps	1,373			1,486			2,491			4,600
Mirror swaps with counterparties	Net gains (losses) on interest rate swaps	(1,419		)	(1,546		)	(2,497		)	(4,713		)
Total		$	(836	)	$	(81	)	$	(1,269	)	$	(471	)