Derivative Financial Instruments

9 Months Ended

Sep. 30, 2017

Derivative Financial Instruments

Derivative Financial Instruments

17. Derivative Financial Instruments

The Company uses various derivative financial instruments to mitigate interest rate risk. The Bank’s interest rate risk management strategy involves effectively managing the re-pricing characteristics of certain assets and liabilities to mitigate potential adverse impacts from changes in interest rates on the net interest margin. PrimeLending has interest rate risk relative to interest rate lock commitments (“IRLCs”) and its inventory of mortgage loans held for sale. PrimeLending is exposed to such interest rate risk from the time an IRLC is made to an applicant to the time the related mortgage loan is sold. To mitigate interest rate risk, PrimeLending executes forward commitments to sell mortgage-backed securities (“MBSs”). Additionally, PrimeLending has interest rate risk relative to its MSR asset and uses derivative instruments, including interest rate swaps, swaptions, and U.S. Treasury bond futures and options to hedge this risk. The Hilltop Broker-Dealers use forward commitments to both purchase and sell MBSs to facilitate customer transactions and as a means to hedge related exposure to interest rate risk in certain inventory positions.

Non-Hedging Derivative Instruments and the Fair Value Option

As discussed in Note 3 to the consolidated financial statements, the Company has elected to measure substantially all mortgage loans held for sale at fair value under the provisions of the Fair Value Option. The election provides the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without applying complex hedge accounting provisions. The fair values of PrimeLending’s IRLCs, forward commitments, interest rate swaps and swaptions, and U.S. Treasury bond futures and options are recorded in other assets or other liabilities, as appropriate, and changes in the fair values of these derivative instruments are recorded as a component of net gains from sale of loans and other mortgage production income. The fair value of PrimeLending’s derivative instruments decreased $9.9 million during the three months ended September 30, 2017, compared with an increase of $1.2 million during the three months ended September 30, 2016, while the fair values of PrimeLending’s derivatives decreased $0.4 million and $13.0 million during the nine months ended September 30, 2017 and 2016, respectively. Changes in fair value are attributable to changes in the volume of IRLCs, mortgage loans held for sale, commitments to purchase and sell MBSs and MSR assets, and changes in market interest rates. Changes in market interest rates also conversely affect the value of PrimeLending’s mortgage loans held for sale and its MSR asset, which are measured at fair value under the Fair Value Option. The effect of the change in market interest rates on PrimeLending’s loans held for sale and MSR asset is discussed in Note 3 to the consolidated financial statements. The fair values of the Hilltop Broker-Dealers’ and the Bank’s derivative instruments are recorded in other assets or other liabilities, as appropriate. The fair values of the Hilltop Broker-Dealers’ derivatives decreased $3.6 million and  $8.5 million during the three months ended September 30, 2017 and 2016, respectively, while the fair values of the Bank’s derivatives increased $49 thousand  during the three months ended September 30, 2017, compared with an increase of $0.3 million during the three months ended September 30, 2016. The fair values of the Hilltop Broker-Dealers’ derivatives increased $12.6 million and $1.0 million during the nine months ended September 30, 2017 and 2016, respectively, while the fair values of the Bank’s derivatives increased $0.2 million during the nine months ended September 30, 2017, compared with a decrease of $0.3 million during the nine months ended September 30, 2016. The changes in fair value were recorded as a component of other noninterest income.

Derivative positions are presented in the following table (in thousands).

	September 30, 2017				December 31, 2016
	Notional		Estimated		Notional		Estimated
	Amount		Fair Value		Amount		Fair Value
Derivative instruments:
IRLCs	$	1,248,422	$	28,601	$	944,550	$	23,269
Customer-based written options		14,930		30		—		—
Customer-based purchased options		14,930		(30)		—		—
Commitments to purchase MBSs		3,198,208		7,040		3,616,922		(1,155)
Commitments to sell MBSs		5,878,986		2,517		5,609,250		(532)
Interest rate swaps and swaptions		28,152		(95)		32,452		(283)
U.S. Treasury bond futures and options (1)		194,000		—		297,000		—

(1)    Changes in the fair value of these contracts are settled daily with PrimeLending’s counterparty.

PrimeLending had cash collateral advances totaling $3.7 million to offset net liability derivative positions on its commitments to sell MBSs at September 30, 2017, compared to a payable of $19.1 million on its net liability derivative position on its commitments to sell MBSs at December 31, 2016. In addition, PrimeLending advanced cash collateral totaling $3.2 million on its U.S. Treasury bond futures and options at both September 30, 2017 and December 31, 2016. These amounts are included in other assets within the consolidated balance sheets.