DERIVATIVE INSTRUMENTS
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DERIVATIVE INSTRUMENTS | 14. DERIVATIVE INSTRUMENTS We utilize an overall risk management strategy that incorporates the use of derivative instruments to reduce interest rate risk, as it relates to mortgage loan commitments and planned sales, and foreign currency volatility. We also use these instruments to accommodate our clients as we provide them with risk management solutions. Additionally, we hold warrants received from borrowers in connection with loan restructurings that are accounted for as derivatives. None of the above-mentioned end-user and client-related derivatives were designated as hedging instruments at June 30, 2012 and December 31, 2011. We also use interest rate derivatives to hedge interest rate risk in our loan portfolio which is comprised primarily of floating rate loans. These derivatives are designated as cash flow hedges. Derivatives expose us to counterparty credit risk. Credit risk is managed through our standard underwriting process. Actual exposures are monitored against various types of credit limits established to contain risk within parameters. Additionally, credit risk is managed through the use of collateral and netting agreements.
Composition of Derivative Instruments and Fair Value (Amounts in thousands)
Certain of our derivative contracts contain embedded credit risk contingent features that if triggered either allow the derivative counterparty to terminate the derivative or require additional collateral. These contingent features are triggered if we do not meet specified financial performance indicators such as minimum capital ratios under the federal banking agencies’ guidelines. All requirements were met on June 30, 2012 and December 31, 2011.
Details on these derivative contracts are set forth in the following table. Derivatives Subject to Credit Risk Contingency Features (Amounts in thousands)
Derivatives Designated in Hedge Relationships The objective of our hedging program is to use interest rate derivatives to manage our exposure to interest rate movements. Cash flow hedges –In the third quarter 2011, we began a cash flow hedging program by entering into receive fixed/pay variable interest rate swaps to convert certain floating-rate commercial loans to fixed rate to reduce the variability in forecasted interest cash flows due to market interest rate changes. We use regression analysis to assess the effectiveness of cash flow hedges at both the inception of the hedge relationship and on an ongoing basis. Ineffectiveness is generally measured as the amount by which the cumulative change in fair value of the hedging instrument exceeds the present value of the cumulative change in the expected cash flows of the hedged item. Measured ineffectiveness is recognized directly in other non-interest income in the Consolidated Statements of Income. The effective portion of the gains or losses on cash flow hedges are recorded, net of tax, in accumulated other comprehensive income (“AOCI”) and are subsequently reclassified to interest income on loans in the period that the hedged interest cash flows affect earnings. As of June 30, 2012, the maximum length of time over which forecasted interest cash flows are hedged is six years. There are no components of derivative gains or losses excluded from the assessment of hedge effectiveness related to our cash flow hedge strategy. Change in Accumulated Other Comprehensive Income Related to Interest Rate Swaps Designated as Cash Flow Hedge (Amounts in thousands)
As of June 30, 2012, $1.8 million in net deferred gains, net of tax, recorded in AOCI are expected to be reclassified into earnings during the next twelve months. This amount could differ from amounts actually recognized due to changes in interest rates, hedge de-designations, and the addition of other hedges subsequent to June 30, 2012. During the first six months of 2012, there were no gains or losses from cash flow hedge derivatives related to ineffectiveness that were reclassified to current earnings. We are required to reclassify such gains or losses related to ineffectiveness in circumstances where the original forecasted transaction was no longer probable of occurring.
Derivatives Not Designated in Hedge Relationships End-User Derivatives – We enter into derivatives that include commitments to fund certain mortgage loans to be sold into the secondary market and forward commitments for the future delivery of residential mortgage loans. It is our practice to enter into forward commitments for the future delivery of residential mortgage loans when customer interest rate lock commitments are entered into to economically hedge the effect of changes in interest rates on our commitments to fund the loans as well as on our portfolio of mortgage loans held-for-sale which totaled $35.3 million at June 30, 2012. At June 30, 2012, we had approximately $160.6 million of interest rate lock commitments and $195.9 million of forward commitments for the future delivery of residential mortgage loans with rate locks at rates consistent with the lock commitment. We are also exposed at times to foreign exchange risk as a result of issuing loans in which the principal and interest are settled in a currency other than U.S. dollars. Currently our exposure is to the Euro on $352,000 of loans and we manage this risk by using currency forward derivatives. We also hold warrants received from one borrower in connection with a loan restructuring that are accounted for as derivative assets. At June 30, 2012, the fair value of these warrants was $19,000. Client Related Derivatives – We offer, through our capital markets group, over-the-counter interest rate and foreign exchange derivatives to our clients, including but not limited to, interest rate swaps, options on interest rate swaps, interest rate options (also referred to as caps, floors, collars, etc.), foreign exchange forwards, and options as well as cash products such as foreign exchange spot transactions. When our clients enter into an interest rate or foreign exchange derivative transaction with us, we mitigate our exposure to market risk through the execution of off-setting positions with inter-bank dealer counterparties. Although the off-setting nature of transactions originated by our capital markets group limit our market risk exposure, they do expose us to other risks including counterparty credit, settlement, and operational risk. To accommodate our loan clients, we occasionally enter into risk participation agreements (“RPA”) with counterparty banks to either accept or transfer a portion of the credit risk related to their interest rate derivatives. This allows clients to execute an interest rate derivative with one bank while allowing for distribution of the credit risk among participating members. We have entered into written RPAs in which we accept a portion of the credit risk associated with a loan client’s interest rate derivative in exchange for a fee. We manage this credit risk through our loan underwriting process, and when appropriate, the RPA is backed by collateral provided by our clients under their loan agreement. The current payment/performance risk of written RPAs is assessed using internal risk ratings which range from 1 to 8 with the latter representing the highest credit risk. The risk rating is based on several factors including the financial condition of the RPA’s underlying derivative counterparty, present economic conditions, performance trends, leverage, and liquidity. The maximum potential amount of future undiscounted payments that we could be required to make under our written RPAs assumes that the underlying derivative counterparty defaults and that the floating interest rate index of the underlying derivative remains at zero percent. In the event that we would have to pay out any amounts under our RPAs, we will seek to maximize the recovery of these amounts from assets that our clients pledged as collateral for the derivative and the related loan. Risk Participation Agreements (Dollars in thousands)
Gain (Loss) Recognized on Derivative Instruments Not Designated in Hedging Relationship (Amounts in thousands)
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