Derivative Financial Instruments

9 Months Ended

Sep. 30, 2012

Derivative Financial Instruments

NOTE 9. Derivative Financial Instruments

Risk Management Objective of Using Derivatives

Susquehanna is exposed to certain risks arising from both its business operations and economic conditions. Susquehanna manages economic risk exposures, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and through the use of derivative financial instruments. Susquehanna enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are impacted by changes in interest rates. Susquehanna’s derivative financial instruments are used to manage differences in the amount, timing, and duration of its known or expected cash payments principally those related to certain variable-rate liabilities. Susquehanna also has derivatives that are a result of a service it provides to certain qualifying customers. Susquehanna manages a matched book with respect to its derivative instruments offered as a part of this service to its customers in order to minimize its interest rate risk resulting from such transactions. All derivatives are recorded at fair value.

Derivatives may expose Susquehanna to market, credit or liquidity risks in excess of the amounts recorded on the consolidated balance sheets. Market risk of a derivative is the exposure created by potential fluctuations in interest rates and other factors and is a function of the type of derivative, the tenor and terms of the agreement, and the underlying volatility. Credit risk is the exposure to loss in the event of nonperformance by the other party to the transaction where the value of any collateral held is not adequate to cover such losses. Liquidity risk is the potential exposure that arises when the size of the derivative position may not be able to be rapidly adjusted in periods of high volatility and financial stress at a reasonable cost.

All freestanding derivatives are recorded on the balance sheet at fair value.

Cash Flow Hedges of Interest Rate Risk

Susquehanna uses interest rate derivatives to manage its exposure to interest rate movements and add stability to interest income and expense. Susquehanna primarily uses interest rate swaps as part of its interest rate risk management strategy. For example, Susquehanna may issue variable rate debt and then enter into a receive-variable pay-fixed-rate interest rate swap with the same payment timing and notional amount to convert the interest payments to a net fixed-rate basis for all or a portion of the term of the long-term debt. As of September 30, 2012, Susquehanna had 14 interest rate swaps with an aggregate notional amount of $1,156,473 that were designated as cash flow hedges of interest-rate risk.

Susquehanna applies hedge accounting to certain interest rate derivatives entered into for risk management purposes. To qualify for hedge accounting, a derivative must be highly effective at reducing the risk associated with the exposure being hedged. In addition, key aspects of achieving hedge accounting are documentation of hedging strategy and hedge effectiveness at the hedge inception and substantiating hedge effectiveness on an ongoing basis. A derivative must be highly effective in accomplishing the hedge objective of offsetting either changes in the fair value or cash flows of the hedged item for the risk being hedged. Any ineffectiveness in the hedge relationship is recognized in current earnings. The assessment of effectiveness excludes changes in the value of the hedged item that are unrelated to the risks being hedged. The effective portion of changes in the fair value of derivatives designated in a hedge relationship and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged transaction affects earnings.

Amounts recorded in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on Susquehanna’s variable-rate liabilities. During the next 12 months, Susquehanna estimates that $18,600 will be reclassified as an expense to net interest income.

Non-designated Derivatives

Derivatives not designated as hedges are used to manage Susquehanna’s exposure to interest rate movements and other identified risks but do not meet the strict requirements of hedge accounting. Changes in the fair value of derivatives not designated in hedging relationships are recognized directly in earnings.

Susquehanna does not seek to apply hedge accounting to all of the derivatives involved in Susquehanna’s risk management activities, such as the interest rate derivatives entered into to offset the derivatives offered to qualifying borrowers. Susquehanna offers qualifying commercial banking customers derivatives to enable such customers to transfer, modify or reduce their interest rate risks. The credit risk associated with derivatives entered into with these customers is essentially the same as that involved in extending loans and is subject to our normal credit policies. Susquehanna obtains collateral based upon its assessment of the customers’ credit quality. Susquehanna actively manages the market risks from its exposure to these derivatives by entering into offsetting derivative transactions, controls focused on pricing, and reporting of positions to senior managers to minimize its exposure resulting from such transactions.

At September 30, 2012, Susquehanna had 168 derivative transactions related to this program with an aggregate notional amount of $890,124. For the three-month and nine month periods ended September 30, 2012, Susquehanna recognized a net loss of $4,064, and $4,870, respectively, related to changes in fair value of the derivatives in this program.

Credit-risk-related Contingent Features

Susquehanna has agreements with certain of its derivative counterparties that contain the following provisions:

• if Susquehanna defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then Susquehanna could also be declared in default on its derivative obligations;

• if Susquehanna fails to maintain its status as a well/adequately capitalized institution, then the counterparty could terminate the derivative positions, and Susquehanna would be required to settle its obligations under the agreements;

• if Susquehanna fails to maintain a specified minimum leverage ratio, then Susquehanna could be declared in default on its derivative obligations;

• if Susquehanna’s credit rating is reduced below investment grade, then a termination event will be deemed to have occurred and Susquehanna’s counterparty would have the right, but not the obligation, to terminate all transactions under the agreement.

At September 30, 2012, the fair value of derivatives in a net liability position, which includes accrued interest and any credit valuation adjustments related to these agreements, was $57,946. At September 30, 2012, Susquehanna had minimum collateral posting thresholds with certain of its derivative counterparties and had posted collateral of $75,490. If Susquehanna had breached any of the above provisions at September 30, 2012, it would have been required to settle its obligations under the agreements at termination value and would have been required to pay any additional amounts due in excess of amounts previously posted as collateral with the respective counterparty.

Fair Value of Derivative Instruments

	Fair Values of Derivative Instruments September 30, 2012
	Asset Derivatives			Liability Derivatives
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Derivatives designated as hedging instruments
Interest rate contracts	Other assets	$	964	Other liabilities	$	55,789
Derivatives not designated as hedging instruments
Interest rate contracts	Other assets		27,775	Other liabilities		23,487
Total derivatives		$	28,739		$	79,276
	Fair Values of Derivative Instruments December 31, 2011
	Asset Derivatives			Liability Derivatives
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Derivatives designated as hedging instruments
Interest rate contracts	Other assets	$	3,693	Other liabilities	$	52,028
Derivatives not designated as hedging instruments
Interest rate contracts	Other assets		22,770	Other liabilities		21,133
Total derivatives		$	26,463		$	73,161

The Effect of Derivative Instruments on Comprehensive Income

	Three Months Ended September 30, 2012
Derivatives in cash flow hedging relationships	Amount of  Loss Recognized in OCI			Location of Loss Reclassified from Accumulated OCI into Income			Amount of Loss Reclassified from Accumulated OCI into Income			Location of Loss Recognized in Income (Ineffective Portion)	Amount of Loss Recognized in Income (Ineffective Portion)
Interest rate contracts:	$	(1,659	)		Interest expense		$	(4,434	)	Other expense	$	0
Derivatives not designated as hedging instruments	Location of Loss Recognized in Income on Derivatives			Amount of Loss Recognized in Income on Derivatives
Interest rate contracts:		Other income		$	(4,054	)
		Other expense			(10	)
	Three Months Ended September 30, 2011
Derivatives in cash flow hedging relationships	Amount of Loss Recognized in OCI			Location of Loss Reclassified from Accumulated OCI into Income			Amount of Loss Reclassified from Accumulated OCI into Income			Location of Gain Recognized in Income (Ineffective Portion)	Amount of Gain Recognized in Income (Ineffective Portion)
Interest rate contracts:	$	(10,511	)		Interest expense		$	(4,687	)	Other expense	$	291
Derivatives not designated as hedging instruments	Location of Loss Recognized in Income on Derivatives			Amount of Loss Recognized in Income on Derivatives
Interest rate contracts:		Other income		$	(362	)
		Other expense			(36	)
	Nine Months Ended September 30, 2012
Derivatives in cash flow hedging relationships	Amount of Loss Recognized in OCI			Location of Loss Reclassified from Accumulated OCI into Income			Amount of Loss Reclassified from Accumulated OCI into Income			Location of Loss Recognized in Income (Ineffective Portion)	Amount of Loss Recognized in Income (Ineffective Portion)
Interest rate contracts:	$	(4,139	)		Interest expense		$	(13,083	)	Other expense	$	0
Derivatives not designated as hedging instruments	Location of Loss Recognized in Income on Derivatives			Amount of Loss Recognized in Income on Derivatives
Interest rate contracts:		Other income		$	(4,823	)
		Other expense			(47	)

	Nine Months Ended September 30, 2011
Derivatives in cash flow hedging relationships	Amount of Loss Recognized in OCI			Location of Loss Reclassified from Accumulated OCI into Income			Amount of Loss Reclassified from Accumulated OCI into Income			Location of Gain Recognized in Income (Ineffective Portion)	Amount of Gain Recognized in Income (Ineffective Portion)
Interest rate contracts:	$	(15,286	)		Interest expense		$	(12,312	)	Other expense	$	509
Derivatives not designated as hedging instruments	Location of Gain (Loss) Recognized in Income on Derivatives			Amount of Gain (Loss) Recognized in Income on Derivatives
Interest rate contracts:		Other income		$	152
		Other expense			(159	)