Derivative Financial Instruments

Risk Management Strategy

We maintain an overall interest rate risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate changes. Our goal is to manage interest rate sensitivity by modifying the repricing frequency and underlying index characteristics of certain balance sheet assets or liabilities so any adverse impacts related to movements in interest rates are managed within low to moderate limits. As a result of interest rate fluctuations, hedged balance sheet positions will appreciate or depreciate in market value or create variability in cash flows. Income or loss on the derivative instruments linked to the hedged item will generally offset the effect of this unrealized appreciation or depreciation or volatility in cash flows for the period the item is being hedged. We view this strategy as a prudent management of interest rate risk.

Although we use derivatives to reduce the risk of interest rate changes, the use of derivatives does expose us to both market and credit risk. Market risk is the chance of financial loss resulting from changes in interest rates and market liquidity. Credit risk is the risk that a counterparty will not perform its obligations under a contract and it is limited to the loss of the fair value gain in a derivative that the counterparty owes us less collateral held and plus collateral posted. When the fair value of a derivative contract less collateral held and plus collateral posted is negative, we owe the counterparty and, therefore, we have no credit risk exposure to the counterparty; however, the counterparty has exposure to us. We minimize the credit risk in derivative instruments by entering into transactions with reputable counterparties that are reviewed regularly by our Credit Department. We also maintain a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association, Inc. Master Agreement. Depending on the nature of the derivative transaction, bilateral collateral arrangements are required as well. When we have more than one outstanding derivative transaction with the counterparty, and there exists legally enforceable netting provisions with the counterparty (i.e., a legal right to offset receivable and payable derivative contracts), the “net” mark-to-market exposure, less collateral held and plus collateral posted, represents exposure with the counterparty. We refer to this as the “net position.” When there is a net negative exposure, we consider our exposure to the counterparty and the net position to be zero.

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires all standardized derivatives, including most interest rate swaps, to be submitted for clearing to central counterparties to reduce counterparty risk. Two of the central counterparties we use are the CME and the LCH. The CME and the LCH made amendments to their respective rules that resulted in the prospective accounting treatment of certain daily variation margin payments being considered as the legal settlement of the outstanding exposure of the derivative instead of the posting of collateral. The CME rule changes, which became effective in January 2017, result in all variation margin payments on derivatives cleared through the CME being accounted for as legal settlement, while the LCH allows the clearing member institution the option to adopt the rule changes on an individual contract or portfolio basis. As of December 31, 2017, $4.8 billion notional of our derivative contracts were cleared on the CME and $0.7 billion were cleared on the LCH. The derivative contracts cleared through the CME and LCH represent 87.6 percent and 12.4 percent, respectively, of our total notional derivative contracts of $5.5 billion at December 31, 2017.

Under this new rule, for derivatives cleared through the CME, the net gain (loss) position includes the variation margin amounts as settlement of the derivative and not collateral against the fair value of the derivative. Interest income (expense) related to variation margin on derivatives that are not designated as hedging instruments or are designated as fair value relationships is recognized as a gain (loss) rather than as interest income (expense). Changes in fair value for derivatives not designated as hedging instruments will be presented as realized gains (losses).

Our LCH clearing member institution has elected not to adopt the new rule change. Therefore, there has been no change to the accounting for the derivatives cleared through the LCH, and variation margin payments required to be exchanged based on the fair value of those derivatives remain accounted for as collateral.

Our exposure is limited to the value of the derivative contracts in a gain position less any collateral held and plus any collateral posted. When there is a net negative exposure, we consider our exposure to the counterparty to be zero. At December 31, 2017 and 2016, we had a net positive exposure (derivative gain positions to us, less collateral held by us and plus collateral posted with counterparties) related to derivatives of $19.6 million and $44.6 million, respectively.

Accounting for Derivative Instruments

The accounting for derivative instruments requires that every derivative instrument, including certain derivative instruments embedded in other contracts, be recorded on the balance sheet as either an asset or liability measured at fair value. Our derivative instruments are classified and accounted for by us as fair value hedges, cash flow hedges, and trading hedges.

Fair Value Hedges

We generally use fair value hedges to offset the exposure to changes in fair value of a recognized fixed-rate liability. We enter into interest rate swaps to economically convert fixed-rate debt into variable-rate debt. For fair value hedges, we generally consider all components of the derivative’s gain and/or loss when assessing hedge effectiveness and generally hedge changes in fair values due to interest rates.

Cash Flow Hedges

We use cash flow hedges to hedge the exposure to variability in cash flows of floating-rate deposits. This strategy is used primarily to minimize the exposure to volatility in cash flows from future changes in interest rates. Gains and losses on the effective portion of a qualifying hedge are recorded in accumulated other comprehensive income and ineffectiveness is recorded immediately to earnings. In assessing hedge effectiveness, generally all components of each derivative’s gains or losses are included in the assessment. We hedge exposure to changes in cash flows due to changes in interest rates or total changes in cash flow.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on our variable-rate deposits. During the next twelve months, we estimate that $1.8 million will be reclassified as an increase to interest expense.

Trading Activities

When derivative instruments do not qualify for hedge accounting treatment, they are accounted for at fair value with all changes in fair value recorded through earnings. All our derivative instruments entered into after December 31, 2013 with a maturity of less than 3 years are economically hedging risk, but do not receive hedge accounting treatment. Trading derivatives also include any hedges that originally received hedge accounting treatment, but lost hedge accounting treatment due to failed effectiveness testing, as well as the activity of certain derivatives prior to those derivatives receiving hedge accounting treatment.

Summary of Derivative Financial Statement Impact

The following tables summarize the fair values and notional amounts of all derivative instruments at December 31, 2017 and 2016, and their impact on earnings and other comprehensive income for the years ended December 31, 2017, 2016 and 2015. The net fair value of derivative instruments as of December 31, 2017 was a liability of $1.8 million, compared to the net fair value as of December 31, 2016 liability of $18.1 million. The change in the net fair value reflects a $3.5 million decrease in fair value offset by variation margin amounts of $19.9 million. The net position as of December 31, 2017 was a $19.8 million liability, compared to a $30.0 million liability as of December 31, 2016. The change in the net position reflects a $3.5 million decrease in fair value, $32.1 million decrease in collateral held and pledged (for contracts other than those cleared through the CME), offset by variation margin impacts of $25.4 million.

Impact of Derivatives on the Consolidated Balance Sheets



		Cash Flow Hedges						Fair Value Hedges					Trading					Total
		December 31,			December 31,			December 31,		December 31,			December 31,		December 31,			December 31,			December 31,
		2017			2016			2017		2016			2017		2016			2017			2016
Fair Values⁽¹⁾	Hedged Risk Exposure

Derivative Assets:⁽²⁾
Interest rate swaps	Interest rate	$	—		$	—		$	630	$	7,808		$	182	$	—		$	812		$	7,808
Derivative Liabilities:⁽²⁾
Interest rate swaps	Interest rate	(2,584		)	(14,463		)	—		(10,398		)	—		(1,076		)	(2,584		)	(25,937		)
Total net derivatives		$	(2,584	)	$	(14,463	)	$	630	$	(2,590	)	$	182	$	(1,076	)	$	(1,772	)	$	(18,129	)

(1)

Except for instruments cleared through the CME, fair values reported are exclusive of collateral held and pledged and accrued interest. Assets and liabilities are presented without consideration of master netting agreements. Derivatives are carried on the balance sheet based on net position by counterparty under master netting agreements, and classified in other assets or other liabilities depending on whether in a net positive or negative position. The net position includes the variation margin as legal settlement of the derivative contract for instruments cleared through the CME.


(2)	The following table reconciles gross positions with the impact of master netting agreements to the balance sheet classification:



	Other Assets						Other Liabilities
	December 31,			December 31,			December 31,			December 31,
	2017			2016			2017			2016
Gross position⁽¹⁾	$	812		$	7,808		$	(2,584	)	$	(25,937	)
Impact of master netting agreement	(812		)	(7,808		)	812			7,808
Derivative values with impact of master netting agreements (as carried on balance sheet)	—			—			(1,772		)	(18,129		)
Cash collateral (held) pledged⁽²⁾	—			—			21,586			48,134
Net position	$	—		$	—		$	19,814		$	30,005


(1)	Except for instruments cleared with the CME, gross position amounts are exclusive of accrued interest and collateral held and pledged.


(2)	Cash collateral (held) pledged excludes amounts that represent legal settlement of the derivative contracts.



	Cash Flow				Fair Value				Trading				Total
	December 31,		December 31,		December 31,		December 31,		December 31,		December 31,		December 31,		December 31,
	2017		2016		2017		2016		2017		2016		2017		2016
Notional Values

Interest rate swaps	$	1,408,649	$	1,054,688	$	3,062,849	$	3,628,062	$	987,577	$	494,638	$	5,459,075	$	5,177,388

Impact of Derivatives on the Consolidated Statements of Income



	Years Ended December 31,
	2017			2016			2015

Fair Value Hedges
Interest rate swaps:
Hedge ineffectiveness realized gains (losses) recorded in earnings⁽¹⁾	$	(4,557	)	$	(1,035	)	$	2,695
Realized gains recorded in interest expense	8,286			27,810			29,940
Total	$	3,729		$	26,775		$	32,635

Cash Flow Hedges
Interest rate swaps:
Hedge ineffectiveness gains (losses) recorded in earnings⁽¹⁾	$	53		$	(1,579	)	$	(1,427	)
Realized losses recorded in interest expense	(11,187		)	(17,665		)	(21,475		)
Total	$	(11,134	)	$	(19,244	)	$	(22,902	)

Trading
Interest rate swaps:
Interest reclassification	$	(69	)	$	2,170		$	3,451
Realized gains (losses) recorded in earnings	(3,693		)	(513		)	581
Total⁽¹⁾	(3,762		)	1,657			4,032
Total	$	(11,167	)	$	9,188		$	13,765

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(1)Amounts included in “gains (losses) on derivatives and hedging activities, net” in the consolidated statements of income.

Impact of Derivatives on the Statements of Changes in Stockholders’ Equity



	Years Ended December 31,
	2017			2016			2015
Amount of gain (loss) recognized in other comprehensive income (loss)	$	8,008		$	(3,901	)	$	(26,699	)
Amount of loss reclassified in interest expense⁽¹⁾	(11,187		)	(17,665		)	(21,475		)
Total change in other comprehensive income (loss) for unrealized gains (losses) on derivatives, before income tax (expense) benefit	$	19,195		$	13,764		$	(5,224	)

______


(1)	Amounts included in “realized losses recorded in interest expense” in the “Impact of Derivatives on the Consolidated Statements of Income” table.

Cash Collateral

As of December 31, 2017, cash collateral held and pledged excludes amounts that represent legal settlement of the derivative contracts held with the CME. Cash collateral held related to derivative exposure between us and our derivatives counterparties was $0 and $1.0 million at December 31, 2017 and 2016, respectively. Collateral held is recorded in “Other Liabilities” on the consolidated balance sheets. Cash collateral pledged related to derivative exposure between us and our derivatives counterparties was $21.6 million and $49.1 million at December 31, 2017 and 2016, respectively. Collateral pledged is recorded in “Other interest-earning assets” on the consolidated balance sheets.