DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

9 Months Ended

Sep. 30, 2012

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

NOTE 13. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

As of September 30, 2012, the Company held derivatives with a total notional amount of $1.3 billion.  That amount included $270.0 million in interest rate swap derivatives that were designated as cash flow hedges for accounting purposes.  The Company also had economic hedges and non-hedging derivatives totaling $741.6 million and $275.8 million, respectively, which are not designated as accounting hedges.  Economic hedges included interest rate swaps totaling $410.9 million, and $330.6 million in forward commitment contracts.

As part of the Company’s risk management strategy, the Company enters into interest rate swap agreements to mitigate the interest rate risk inherent in certain of the Company’s assets and liabilities. Interest rate swap agreements involve the risk of dealing with both Bank customers and institutional derivative counterparties and their ability to meet contractual terms. The agreements are entered into with counterparties that meet established credit standards and contain master netting and collateral provisions protecting the at-risk party. The derivatives program is overseen by the Risk Management Committee of the Company’s Board of Directors. Based on adherence to the Company’s credit standards and the presence of the netting and collateral provisions, the Company believes that the credit risk inherent in these contracts was not significant at September 30, 2012.

The Company pledged collateral to derivative counterparties in the form of cash totaling $5.3 million and securities with an amortized cost of $34.3 million and a fair value of $35.2 million as of September 30, 2012. The Company does not typically require its Commercial customers to post cash or securities as collateral on its program of back-to-back economic hedges. However certain language is written into the ISDA and loan documents where, in default situations, the Bank is allowed to access collateral supporting the loan relationship to recover any losses suffered on the derivative asset or liability. The Company may need to post additional collateral in the future in proportion to potential increases in unrealized loss positions.

Information about interest rate swap agreements and non-hedging derivative assets and liabilities at September 30, 2012, follows:

			Weighted					Estimated
	Notional		Average	Weighted Average Rate				Fair Value
	Amount		Maturity	Received		Paid		Asset (Liability)
	(In thousands)		(In years)					(In thousands)
Cash flow hedges:
Interest rate swaps on FHLBB borrowings	$	115,000	1.8	0.44	%	3.47	%	$	(5,509	)
Forward-starting interest rate swaps on FHLBB borrowings	140,000		5.7	—	%	2.37	%	(5,920		)
Interest rate swaps on junior subordinated debentures	15,000		1.6	2.28	%	5.54	%	(829		)
Total cash flow hedges	270,000							(12,258		)
Economic hedges:
Interest rate swap on tax advantaged economic development bond	13,734		17.2	0.60	%	5.09	%	(3,719		)
Interest rate swaps on loans with commercial loan customers	198,600		5.2	2.58	%	5.35	%	(16,290		)
Reverse interest rate swaps on loans with commercial loan customers	198,600		5.2	5.35	%	2.58	%	15,747
Forward commitments	330,632		0.2					(4,669		)
Total economic hedges	741,566							(8,931		)
Non-hedging derivatives:
Interest rate lock commitments	275,756		0.2					7,833
Total non-hedging derivatives	275,756							7,833
Total	$	1,287,322						$	(13,356	)

Information about interest rate swap agreements and non-hedging derivative assets and liabilities at December 31, 2011, follows:

			Weighted					Estimated
	Notional		Average	Weighted Average Rate				Fair Value
	Amount		Maturity	Received		Paid		Asset (Liability)
	(In thousands)		(In years)					(In thousands)
Cash flow hedges:
Interest rate swaps on FHLBB borrowings	$	105,000	1.7	0.49	%	4.00	%	$	(5,888	)
Forward-starting interest rate swaps on FHLBB borrowings	80,000		3.5	—		2.56	%	(2,064		)
Interest rate swaps on junior subordinated debentures	15,000		2.4	2.35	%	5.54	%	(1,055		)
Total cash flow hedges	200,000							(9,007		)
Economic hedges:
Interest rate swap on tax advantaged economic development bond	14,096		17.9	0.64	%	5.09	%	(3,505		)
Interest rate swaps on loans with commercial loan customers	160,389		5.6	2.73	%	5.77	%	(14,351		)
Reverse interest rate swaps on loans with commercial loan customers	160,389		5.6	5.77	%	2.73	%	13,871
Forward commitments	21,538		0.2					55
Total economic hedges	356,412							(3,930		)
Non-hedging derivatives:
Interest rate lock commitments	21,538		0.2					(66		)
Total non-hedging derivatives	21,538							(66		)
Total	$	577,950						$	(13,003	)

Cash flow hedges

The effective portion of unrealized changes in the fair value of derivatives accounted for as cash flow hedges is reported in other comprehensive income and subsequently reclassified to earnings in the same period or periods during which the hedged forecasted transaction affects earnings. Each quarter, the Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged item or transaction. The ineffective portion of changes in the fair value of the derivatives is recognized directly in earnings.

The Company has entered into several interest rate swaps with an aggregate notional amount of $115.0 million to convert the LIBOR based floating interest rates on a $115.0 million portfolio of FHLBB advances to fixed rates, with the objective of fixing the Company’s monthly interest expense on these borrowings.

The Company has also entered into thirteen forward-starting interest rate swaps with a combined notional value of $140.0 million. Of the thirteen forward starting swaps, four will become effective by the close of the second quarter in 2013, two of which have a duration of one year, one with a duration of four years, and the other with a duration of five years. In 2014, seven of the remaining nine forward starting swaps will become effective; of these one has a duration of three years, four have durations of four years, and the final two have durations of five years.  The last two forward starting swaps will become effective in 2015, one of which has a duration of four years and the other of which has a duration of seven years. This hedge strategy converts the LIBOR based rate of interest on certain FHLB advances to fixed interest rates, thereby protecting the Company from floating interest rate variability.

The Company has entered into an interest rate swap with a notional value of $15.0 million to convert the floating rate of interest on its junior subordinated debentures to a fixed rate of interest. The purpose of the hedge was to protect the Company from the risk of variability arising from the floating rate interest on the debentures.

Amounts included in the Consolidated Statements of Income and in the other comprehensive income section of the Consolidated Statements of Changes in Stockholders’ Equity related to interest rate derivatives designated as hedges of cash flows, were as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands)	2012			2011			2012			2011
Interest rate swaps on FHLBB borrowings:
Unrealized (loss) gain recognized in accumulated other comprehensive loss	$	(1,086	)	$	(987	)	$	(3,446	)	$	(544	)
Reclassification of unrealized loss from accumulated other comprehensive loss to non-interest income for hedge ineffectiveness	11			11			31			31
Reclassification of realized gain from accumulated other comprehensive loss to other non-interest income for termination of swaps	235			235			706			706
Reclassification of unrealized deferred tax benefit from accumulated other comprehensive loss to tax expense for terminated swaps	(98		)	(98		)	(226		)	(293		)
Net tax benefit (expense) on items recognized in accumulated other comprehensive loss	441			407			1,448			210
Interest rate swaps on junior subordinated debentures:
Unrealized gain (loss) recognized in accumulated other comprehensive loss	71			(65		)	226			(62		)
Net tax (expense) benefit on items recognized in accumulated other comprehensive loss	(28		)	27			(89		)	24
Other comprehensive income recorded in accumulated other comprehensive loss, net of reclassification adjustments and tax effects	$	(454	)	$	(470	)	$	(1,350	)	$	72
Net interest expense recognized in interest expense on hedged FHLBB borrowings	$	1,121		$	1,239		$	3,327		$	3,663
Net interest expense recognized in interest expense on junior subordinated debentures	$	148		$	131		$	363		$	386

Hedge ineffectiveness on interest rate swaps designated as cash flow hedges was immaterial to the Company’s financial statements during the nine months ended September 30, 2012 and 2011.  The Company does not anticipate material events or transactions within the next twelve months that are likely to result in a reclassification of unrealized gains or losses from accumulated other comprehensive loss to earnings.

Amounts reported in accumulated other comprehensive loss related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate liabilities. During the next twelve months, the Company estimates that $5.3 million will be reclassified as an increase to interest expense.

Economic hedges

The Company has an interest rate swap with a $13.7 million notional amount to swap out the fixed rate of interest on an economic development bond bearing a fixed rate of 5.09%, currently within the Company’s trading portfolio under the fair value option, in exchange for a LIBOR-based floating rate. The intent of the economic hedge is to improve the Company’s asset sensitivity to changing interest rates in anticipation of favorable average floating rates of interest over the 21-year life of the bond.  The fair value changes of the economic development bond are mostly offset by fair value changes of the related interest rate swap.

The Company also offers certain derivative products directly to qualified commercial borrowers.  The Company economically hedges derivative transactions executed with commercial borrowers by entering into mirror-image, offsetting derivatives with third-party financial institutions.  The transaction allows the Company’s customer to convert a variable-rate loan to a fixed rate loan. Because the Company acts as an intermediary for its customer, changes in the fair value of the underlying derivative contracts mostly offset each other in earnings. Credit valuation adjustments arising from the difference in credit worthiness of the commercial loan and financial institution counterparties totaled $502 thousand as of September 30, 2012.  The interest income and expense on these mirror image swaps exactly offset each other.

The Company utilizes forward commitments to hedge interest rate risk and the associated effects on the fair value of interest rate lock commitments and loans held for sale.  The forward commitments are accounted for as derivatives with changes in fair value recorded in current period earnings.

The company uses the following types of forward commitments contracts:

·              Best efforts loan sales,

·              Mandatory delivery loan sales, and

·              To be announced (TBA) mortgage-backed securities sales.

A best efforts contract refers to a loan sales agreement where the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes.  The Company may enter into a best efforts contract once the price is known, which is shortly after the potential borrower’s interest rate is locked.

A mandatory delivery contract is a loan sales agreement where the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date.  Generally, the Company may enter into mandatory delivery contracts shortly after the loan closes with a customer.

The Company may sell to-be-announced mortgage-backed securities to hedge the changes in fair value of interest rate lock comments and held for sale loans, which do not have corresponding best efforts or mandatory delivery contracts.  These security sales transactions are closed once mandatory contracts are written.  On the closing date the price of the security is locked-in, and the sale is paired-off with a purchase of the same security.  Settlement of the security purchase/sale transaction is done with cash on a net-basis.

Non-hedging derivatives

The Company enters into interest rate lock commitments (“IRLCs”) for residential mortgage loans, which commit the Company to lend funds to a potential borrower at a specific interest rate and within a specified period of time.  IRLCs that relate to the origination of mortgage loans that will be held for sale are considered derivative financial instruments under applicable accounting guidance.  Outstanding IRLCs expose the Company to the risk that the price of the mortgage loans underlying the commitments may decline due to increases in mortgage interest rates from inception of the rate lock to the funding of the loan.  The IRLCs are free-standing derivatives which are carried at fair value with changes recorded in noninterest income in the Company’s consolidated statements of income.  Changes in the fair value of IRLCs subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.

Amounts included in the Consolidated Statements of Income related to economic hedges and non-hedging derivatives were as follows:

	Three Months Ended Sept. 30,						Nine Months Ended Sept. 30,
(In thousands)	2012			2011			2012			2011
Economic hedges
Interest rate swap on industrial revenue bond:
Net interest expense recognized in interest and dividend income on securities	$	(158	)	$	(1,812	)	$	(473	)	$	(2,137	)
Unrealized gain recognized in other non-interest income	(24		)	—			(1,118		)	(69		)
Interest rate swaps on loans with commercial loan customers:
Unrealized gain recognized in other non-interest income	859			6,133			4,119			7,073
Reverse interest rate swaps on loans with commercial loan customers:
Unrealized loss recognized in other non-interest income	(859		)	(6,133		)	(4,119		)	(7,073		)
Favorable (unfavorable) change in credit valuation adjustment recognized in other non-interest income	$	(31	)	$	(281	)	$	(22	)	$	(464	)
Forward commitments
Unrealized loss recognized in other non-interest income	$	(6,832	)	$	(182	)	$	(8,963	)	$	(292	)
Non-hedging derivatives
Interest rate lock commitments
Unrealized gain recognized in other non-interest income	$	10,858		$	182		$	15,195		$	256