DERIVATIVES AND HEDGING

The Company, through its Banner Bank subsidiary, is party to various derivative instruments that are used for asset and liability management and customer financing needs. Derivative instruments are contracts between two or more parties that have a notional amount and an underlying variable, require no net investment and allow for the net settlement of positions. The notional amount serves as the basis for the payment provision of the contract and takes the form of units, such as shares or dollars. The underlying variable represents a specified interest rate, index, or other component. The interaction between the notional amount and the underlying variable determines the number of units to be exchanged between the parties and influences the market value of the derivative contract. The Company obtains dealer quotations to value its derivative contracts.

The Company's predominant derivative and hedging activities involve interest rate swaps related to certain term loans and forward sales contracts associated with mortgage banking activities. Generally, these instruments help the Company manage exposure to market risk and meet customer financing needs. Market risk represents the possibility that economic value or net interest income will be adversely affected by fluctuations in external factors such as market-driven interest rates and prices or other economic factors.

Derivatives Designated in Hedge Relationships

The Company's fixed rate loans result in exposure to losses in value or net interest income as interest rates change. The risk management objective for hedging fixed rate loans is to effectively convert the fixed rate received to a floating rate. The Company has hedged exposure to changes in the fair value of certain fixed rate loans through the use of interest rate swaps. For a qualifying fair value hedge, changes in the value of the derivatives are recognized in current period earnings along with the corresponding changes in the fair value of the designated hedged item attributable to the risk being hedged.

In a program brought to Banner Bank through its merger with F&M Bank in 2007, customers received fixed interest rate commercial loans and Banner Bank subsequently hedged that fixed rate loan by entering into an interest rate swap with a dealer counterparty. Banner Bank receives fixed rate payments from the customers on the loans and makes similar fixed rate payments to the dealer counterparty on the swaps in exchange for variable rate payments based on the one-month LIBOR index. Some of these interest rate swaps are designated as fair value hedges. Through application of the “short cut method of accounting,” there is an assumption that the hedges are effective. Banner Bank discontinued originating interest rate swaps under this program in 2008.

As of June 30, 2015 and December 31, 2014, the notional values or contractual amounts and fair values of the Company's derivatives designated in hedge relationships were as follows (in thousands):



	Asset Derivatives								Liability Derivatives
	June 30, 2015				December 31, 2014				June 30, 2015				December 31, 2014
	Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽²⁾		Notional/ Contract Amount		Fair Value ⁽²⁾
Interest rate swaps	$	6,914	$	1,052	$	7,089	$	1,165	$	6,914	$	1,052	$	7,089	$	1,165


⁽¹⁾	Included in Loans receivable on the Consolidated Statements of Financial Condition.


⁽²⁾	Included in Other liabilities on the Consolidated Statements of Financial Condition.

Derivatives Not Designated in Hedge Relationships

Interest Rate Swaps. Banner Bank has been using an interest rate swap program for commercial loan customers, termed the Back-to-Back Program, since 2010. In the Back-to-Back Program, Banner Bank provides the client with a variable rate loan and enters into an interest rate swap in which the client receives a variable rate payment in exchange for a fixed rate payment. Banner Bank offsets its risk exposure by entering into an offsetting interest rate swap with a dealer counterparty for the same notional amount and length of term as the client interest rate swap providing the dealer counterparty with a fixed rate payment in exchange for a variable rate payment. There are also a few interest rate swaps from prior to 2009 that were not designated in hedge relationships that are included in these totals. These swaps do not qualify as designated hedges; therefore, each swap is accounted for as a free standing derivative.

Mortgage Banking. In the normal course of business, the Company sells originated mortgage loans into the secondary mortgage loan markets. During the period of loan origination and prior to the sale of the loans in the secondary market, the Company has exposure to movements in interest rates associated with written rate lock commitments with potential borrowers to originate loans that are intended to be sold and for closed loans that are awaiting sale and delivery into the secondary market.

Written loan commitments that relate to the origination of mortgage loans that will be held for resale are considered free-standing derivatives and do not qualify for hedge accounting. Written loan commitments generally have a term of up to 60 days before the closing of the loan. The loan commitment does not bind the potential borrower to enter into the loan, nor does it guarantee that the Company will approve the potential borrower for the loan. Therefore, when determining fair value, the Company makes estimates of expected “fallout” (loan commitments not expected to close), using models which consider cumulative historical fallout rates, current market interest rates and other factors.

Written loan commitments in which the borrower has locked in an interest rate results in market risk to the Company to the extent market interest rates change from the rate quoted to the borrower. The Company economically hedges the risk of changing interest rates associated with its interest rate lock commitments by entering into forward sales contracts.

Mortgage loans which are held for sale are subject to changes in fair value due to fluctuations in interest rates from the loan's closing date through the date of sale of the loans into the secondary market. Typically, the fair value of these loans declines when interest rates increase and rises when interest rates decrease. To mitigate this risk, the Company enters into forward sales contracts on a significant portion of these loans to provide an economic hedge against those changes in fair value. Mortgage loans held for sale and the forward sales contracts are recorded at fair value with changes in value recorded in current earnings within mortgage banking operations on our Consolidated Statements of Operations.

As of June 30, 2015 and December 31, 2014, the notional values or contractual amounts and fair values of the Company's derivatives not designated in hedge relationships were as follows (in thousands):



	Asset Derivatives								Liability Derivatives
	June 30, 2015				December 31, 2014				June 30, 2015				December 31, 2014
	Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽¹⁾		Notional/ Contract Amount		Fair Value ⁽²⁾		Notional/ Contract Amount		Fair Value ⁽²⁾
Interest rate swaps	$	144,947	$	5,575	$	134,512	$	5,125	$	144,947	$	5,575	$	134,512	$	5,125
Mortgage loan commitments	43,230		311		29,311		317		24,678		148		—		—
Forward sales contracts	67,552		444		—		—		—		—		33,174		198
	$	255,729	$	6,330	$	163,823	$	5,442	$	169,625	$	5,723	$	167,686	$	5,323


⁽¹⁾	Included in Other assets on the Consolidated Statements of Financial Condition, with the exception of those interest rate swaps from prior to 2009 that were not designated in hedge relationships (with a fair value of $416,000 at June 30, 2015 and $558,000 at December 31, 2014), which are included in Loans receivable.


⁽²⁾	Included in Other liabilities on the Consolidated Statements of Financial Condition.

Gains (losses) recognized in income on non-designated hedging instruments for the three and six months ended June 30, 2015 and 2014 were as follows (in thousands):



		Three Months Ended June 30						Six Months Ended June 30
	Location on Statement of Operations	2015			2014			2015		2014
Mortgage loan commitments	Mortgage banking operations	$	(379	)	$	321		$	33	$	391
Forward sales contracts	Mortgage banking operations	595			(199		)	455		(265		)
		$	216		$	122		$	488	$	126

The Company is exposed to credit-related losses in the event of nonperformance by the counterparty to these agreements. Credit risk of the financial contract is controlled through the credit approval, limits, and monitoring procedures and management does not expect the counterparties to fail their obligations.

In connection with the interest rate swaps between Banner Bank and the dealer counterparties, the agreements contain a provision where if Banner Bank fails to maintain its status as a well/adequately capitalized institution, then the counterparty could terminate the derivative positions and Banner Bank would be required to settle its obligations. Similarly, Banner Bank could be required to settle its obligations under certain of its agreements if specific regulatory events occur, such as a publicly issued prompt corrective action directive, cease and desist order, or a capital maintenance agreement that required Banner Bank to maintain a specific capital level. If Banner Bank had breached any of these provisions at June 30, 2015 or December 31, 2014, it could have been required to settle its obligations under the agreements at the termination value. As of June 30, 2015 and December 31, 2014, the termination value of derivatives in a net liability position related to these agreements was $6.6 million and $6.3 million, respectively. The Company generally posts collateral against derivative liabilities in the form of government agency-issued bonds, mortgage-backed securities, or commercial mortgage-backed securities. Collateral posted against derivative liabilities was $15.1 million and $11.1 million as of June 30, 2015 and December 31, 2014, respectively.

Derivative assets and liabilities are recorded at fair value on the balance sheet and do not take into account the effects of master netting agreements. Master netting agreements allow the Company to settle all derivative contracts held with a single counterparty on a net basis and to offset net derivative positions with related collateral where applicable.

The following table illustrates the potential effect of the Company's derivative master netting arrangements, by type of financial instrument, on the Company's Consolidated Statements of Financial Condition as of June 30, 2015 and December 31, 2014 (in thousands):



	June 30, 2015
							Gross Amounts of Financial Instruments Not Offset in the Statement of Financial Condition
	Gross Amounts Recognized		Amounts offset in the Statement of Financial Condition		Net Amounts in the Statement of Financial Condition		Netting Adjustment Per Applicable Master Netting Agreements			Fair Value of Financial Collateral in the Statement of Financial Condition			Net Amount
Derivative assets
Interest rate swaps	$	6,627	$	—	$	6,627	$	(7	)	$	—		$	6,620
	$	6,627	$	—	$	6,627	$	(7	)	$	—		$	6,620

Derivative liabilities
Interest rate swaps	$	6,627	$	—	$	6,627	$	(7	)	$	(6,614	)	$	6
	$	6,627	$	—	$	6,627	$	(7	)	$	(6,614	)	$	6

	December 31, 2014
							Gross Amounts of Financial Instruments Not Offset in the Statement of Financial Condition
	Gross Amounts Recognized		Amounts offset in the Statement of Financial Condition		Net Amounts in the Statement of Financial Condition		Netting Adjustment Per Applicable Master Netting Agreements			Fair Value of Financial Collateral in the Statement of Financial Condition			Net Amount
Derivative assets
Interest rate swaps	$	6,290	$	—	$	6,290	$	(6	)	$	—		$	6,284
	$	6,290	$	—	$	6,290	$	(6	)	$	—		$	6,284

Derivative liabilities
Interest rate swaps	$	6,290	$	—	$	6,290	$	(6	)	$	(6,279	)	$	5
	$	6,290	$	—	$	6,290	$	(6	)	$	(6,279	)	$	5