DERIVATIVES AND HEDGING ACTIVITIES

The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives and foreign exchange contracts to accommodate the business requirements of its customers (“customer related positions”). The Company minimizes the market and liquidity risks of customer-related positions by entering into similar offsetting positions with broker-dealers. Derivative instruments are carried at fair value in the Company’s financial statements. The accounting for changes in the fair value of a derivative instrument is dependent upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.

The Company does not enter into proprietary trading positions for any derivatives.

Interest Rate Positions

The Company currently utilizes interest rate swap agreements as hedging instruments against interest rate risk associated with the Company’s borrowings. An interest rate swap is an agreement whereby one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount, for a predetermined period of time, from a second party. The amounts relating to the notional principal amount are not actually exchanged. The maximum length of time over which the Company is currently hedging its exposure to the variability in future cash flows for forecasted transactions related to the payment of variable interest on existing financial instruments is six years.

The following table reflects the Company’s derivative positions for the periods indicated below for interest rate swaps which qualify as hedges for accounting purposes:



December 31, 2012
Notional Amount		Trade Date	Effective Date	Maturity Date	Receive (Variable) Index	Current Rate Received		Pay Fixed Swap Rate		Fair Value
(Dollars in thousands)
$	25,000	16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.31	%	5.04	%	$	(4,416	)
25,000		16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.31	%	5.04	%	(4,417		)
25,000		8-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.31	%	2.65	%	(553		)
25,000		9-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.31	%	2.59	%	(539		)
25,000		9-Dec-08	10-Dec-08	10-Dec-18	3 Month LIBOR	0.31	%	2.94	%	(2,819		)
50,000		17-Nov-09	20-Dec-10	20-Dec-14	3 Month LIBOR	0.31	%	3.04	%	(2,647		)
25,000		5-May-11	10-Jun-11	10-Jun-15	3 Month LIBOR	0.31	%	1.71	%	(798		)
$	200,000									$	(16,189	)

December 31, 2011
Notional Amount		Trade Date	Effective Date	Maturity Date	Receive (Variable) Index	Current Rate Received		Pay Fixed Swap Rate		Fair Value
(Dollars in thousands)
25,000		16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.55	%	5.04	%	(4,745		)
25,000		16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.55	%	5.04	%	(4,745		)
25,000		8-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.54	%	2.65	%	(941		)
25,000		9-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.54	%	2.59	%	(913		)
25,000		9-Dec-08	10-Dec-08	10-Dec-18	3 Month LIBOR	0.54	%	2.94	%	(2,349		)
50,000		17-Nov-09	20-Dec-10	20-Dec-14	3 Month LIBOR	0.56	%	3.04	%	(3,316		)
25,000		5-May-11	10-Jun-11	10-Jun-15	3 Month LIBOR	0.54	%	1.71	%	(704		)
40,000		18-Aug-11	2-Apr-12	10-Mar-19	3 Month LIBOR	TBD		1.89	%	(550		)
$	240,000									$	(18,263	)

During the first quarter of 2010, one of the Company’s interest rate swap agreements, with a notional amount of $25.0 million, failed to qualify for hedge accounting. The Company ceased hedge accounting on January 6, 2010, which was the last date the interest rate swap qualified for hedge accounting. As a result, the Company recognized a loss of $238,000 directly in earnings as part of noninterest expense and reclassified $107,000 from interest expense to noninterest expense within the first quarter of 2010. Additionally, a gain of $191,000 which was previously deferred in OCI was immediately recognized in income during the first quarter, based on the Company’s anticipation of the hedged forecasted transaction no longer being probable to occur. The Company terminated the swap in June 2010 as a result of management’s decision to pay down the underlying borrowing and recognized $792,000 in earnings through the date of termination.

During 2011, the Company had entered into a forward starting swap with a notional amount of $40.0 million, with the intention of hedging a future federal home loan advance. Subsequently, during the quarter ending March 31, 2012, the Company exited the forward starting swap. At the time of exit, the derivative instrument had a fair value of $22,000, which was received in cash and recognized in other income.

For derivative instruments that are designated and qualify as hedging instruments, the effective portion of the gains or losses is reported as a component of OCI, and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Company expects approximately $5.6 million (pre-tax), to be reclassified to interest expense from OCI, related to the Company’s cash flow hedges in the next twelve months. This reclassification is due to anticipated payments that will be made and/or received on the swaps based upon the forward curve as of December 31, 2012.

The Company had no fair value hedges as of December 31, 2012 and 2011.

The table below presents the net amortization income recognized as an offset to interest expense related to previously terminated swaps for the periods indicated:



	Years Ended December 31
	2012		2011		2010
	(Dollars in thousands)
Net amortization income	$	244	$	244	$	222

Customer Related Positions

Interest rate derivatives, primarily interest-rate swaps, offered to commercial borrowers through the Bank’s loan level derivative program do not qualify as hedges for accounting purposes. The Bank believes that its exposure to commercial customer derivatives is limited because these contracts are simultaneously matched at inception with an offsetting dealer transaction. The commercial customer derivative program allows the Bank to retain variable-rate commercial loans while allowing the customer to synthetically fix the loan rate by entering into a variable-to-fixed interest rate swap.

Foreign exchange contracts offered to commercial borrowers through the Bank’s derivative program do not qualify as hedges for accounting purposes. The Bank acts as a seller and buyer of foreign exchange contracts to accommodate its customers. To mitigate the market and liquidity risk associated with these derivatives, the Bank enters into similar offsetting positions.

The following table reflects the Company’s customer related derivative positions for the periods indicated below for those derivatives not designated as hedging:



	Number of Positions (1)	Notional Amount Maturing
	Number of Positions (1)	2012		2013	2014	2015	Thereafter	Total		Fair Value
	December 31, 2012
	(Dollars in thousands)
Loan level swaps
Receive fixed, pay variable	143	$	—	16,766	65,344	105,939	314,199	$	502,248	28,678
Pay fixed, receive variable	137	$	—	16,766	65,344	105,939	314,199	$	502,248	(28,663	)
Foreign exchange contracts
Buys foreign exchange, sells U.S. currency	16	$	—	42,516	—	—	—	$	42,516	1,748
Buys U.S. currency, sells foreign exchange	16	$	—	42,516	—	—	—	$	42,516	(1,718	)
	December 31, 2011
	(Dollars in thousands)
Loan level swaps
Receive fixed, pay variable	101	$	—	19,197	80,234	112,458	171,533	$	383,422	24,478
Pay fixed, receive variable	101	$	—	19,197	80,234	112,458	171,533	$	383,422	(24,535	)
Foreign exchange contracts
Buys foreign exchange, sells U.S. currency	15	$	21,657	—	—	—	—	$	21,657	(1,081	)
Buys U.S. currency, sells foreign exchange	15	$	21,657	—	—	—	—	$	21,657	1,098

(1) The Company may enter into one swap agreement which offsets multiple reverse swap agreements. The positions will offset and the terms will be identical.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the balance sheet at the periods indicated:



	Asset Derivatives					Liability Derivatives
	Balance Sheet Location	Fair Value at December 31, 2012		Fair Value at December 31, 2011		Balance Sheet Location	Fair Value at December 31, 2012		Fair Value at December 31, 2011
	(Dollars in thousands)
Derivatives designated as hedges
Interest rate swaps	Other assets	$	—	$	—	Other liabilities	$	16,189	$	18,263
Derivatives not designated as hedges
Customer related positions
Loan level swaps	Other assets	$	28,678	$	24,478	Other liabilities	$	28,663	$	24,535
Foreign exchange contracts	Other assets	1,748		1,098		Other liabilities	1,718		1,081
Total		$	30,426	$	25,576		$	30,381	$	25,616

The table below presents the effect of the Company’s derivative financial instruments included in OCI and current earnings for the periods indicated:



	Years Ended December 31
	2012			2011			2010
	(Dollars in thousands)
Derivatives designated as hedges
Loss in OCI on derivative (effective portion), net of tax	$	(2,122	)	$	(7,021	)	$	(7,894	)

Net loss reclassified from OCI into income (effective portion)	$	(5,417	)	$	(5,472	)	$	(3,829	)

Loss recognized in income on derivative (ineffective portion & amount excluded from effectiveness testing):
Interest expense	$	—		$	—		$	—
Other expense	—			—			(154		)
Total	$	—		$	—		$	(154	)

Derivatives not designated as hedges
Changes in fair value of customer related positions:
Other income	$	134		$	164		$	56
Other expense	(49		)	(56		)	(341		)
Total	$	85		$	108		$	(285	)

By using derivatives, the Company is exposed to credit risk to the extent that counterparties to the derivative contracts do not perform as required. Should a counterparty fail to perform under the terms of a derivative contract, the Company’s credit exposure on interest rate swaps is limited to the net positive fair value and accrued interest of all swaps with each counterparty. The Company seeks to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, and obtaining collateral, where appropriate. Institutional counterparties must have an investment grade credit rating and be approved by the Company’s Board of Directors. As such, management believes the risk of incurring credit losses on derivative contracts with those counterparties is remote and losses, if any, would be immaterial. The Company had no exposure relating to interest rate swaps with institutional counterparties at December 31, 2012 or 2011, as all such swaps were in a liability position. The Company’s exposure relating to customer related positions was approximately $31.0 million and $25.1 million at December 31, 2012 and 2011, respectively. Credit exposure may be reduced by the amount of collateral pledged by the counterparty.

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company fails to maintain its status as a well capitalized institution, then the Company could be required to terminate any outstanding derivatives with the counterparty. Certain instruments may also contain credit-risk related contingent features which require the Company to assign collateral for instruments in a liability position. The table below presents information relating to credit-risk contingent instruments as of the dates indicated:



	December 31
	2012		2011
	(Dollars in thousands)
Notional amount	$	702,248	$	623,422
Aggregate fair value	$	44,852	$	42,798
Collateral assigned	$	50,957	$	47,617

Collateral legally required to be maintained at dealer banks by the Company is monitored and adjusted as necessary. The Company determined that no additional collateral would have to be posted to immediately settle these instruments as of December 31, 2012.

The Company does not offset fair value amounts recognized for derivative instruments. The Company does net the amount recognized for the right to reclaim cash collateral against the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement.

Mortgage Derivatives

Forward sale contracts of residential mortgage loans, considered derivative instruments for accounting purposes, are utilized by the Company in its efforts to manage risk of loss associated with its mortgage loan commitments and mortgage loans intended for sale. Prior to closing and funding certain one-to-four family residential mortgage loans, an interest rate lock commitment is generally extended to the borrower. During the period from commitment date to closing date, the Company is subject to the risk that market rates of interest may change. If market rates rise, investors generally will pay less to purchase such loans resulting in a reduction in the gain on sale of the loans or, possibly, a loss. In an effort to mitigate such risk, forward delivery sales commitments are executed, under which the Company agrees to deliver whole mortgage loans to various investors. The interest rate lock commitments and forward sales commitments are recorded at fair value, with changes in fair value recorded in current period earnings as a component of mortgage banking income. The Company has elected the fair value option to carry these instruments at fair value. Changes in the fair value marks on loans held for sale offset changes in interest rate lock and forward sales commitments. The change in fair value of loans held for sale is recorded in current period earnings as a component of mortgage banking income.

The table below summarizes the fair value of residential mortgage loans commitments, forward sales agreements, and loans held for sale at the periods indicated:



	December 31
	2012			2011
	(Dollars in thousands)
Interest rate lock commitments	$	102		$	265
Forward sales agreements	$	(223	)	$	(528	)
Loans held for sale fair value adjustments	$	121		$	262

The table below summarizes the changes in the fair value of residential mortgage loans commitments, forward sales agreements, and loans held for sale for the periods indicated:



	Years Ended December 31
	2012			2011			2010
	(Dollars in thousands)
Interest rate lock commitments	$	(163	)	$	724		$	64
Forward sales agreements	304			(1,580		)	285
Loans held for sale fair value adjustment	(141		)	856			(593		)
Total change in fair value	$	—		$	—		$	(244	)