Derivative Financial Instruments

3 Months Ended

Mar. 31, 2020

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Financial Instruments

DERIVATIVE FINANCIAL INSTRUMENTS

As part of our overall interest rate risk management, Old National uses derivative instruments, including interest rate swaps, collars, caps, and floors.  The notional amount does not represent amounts exchanged by the parties.  The amount exchanged is determined by reference to the notional amount and the other terms of the individual agreements.  The notional amount of these derivative instruments was $905.5 million at March 31, 2020 and $665.5 million at December 31, 2019.  These derivative financial instruments at March 31, 2020 consisted of $380.5 million notional amount of receive-fixed, pay-variable interest rate swaps on certain of its FHLB advances, $125.0 million notional amount of pay-fixed, receive-variable interest rate swaps on certain of its FHLB advances, and $400.0 million notional amount interest rate collars and floors related to variable-rate commercial loan pools.  Derivative financial instruments at December 31, 2019 consisted of $130.5 million notional amount of receive-fixed, pay-variable interest rate swaps on certain of its FHLB advances, $25.0 million notional amount of pay-fixed, receive-variable interest rate swaps on certain of its FHLB advances, and $510.0 million notional amount interest rate collars and floors related to variable-rate commercial loan pools. These hedges were entered into to manage interest rate risk. Derivative instruments are recognized on the balance sheet at their fair value and are not reported on a net basis.

In accordance with ASC 815-20-35-1, subsequent changes in fair value for a hedging instrument that has been designated and qualifies as part of a hedging relationship should be accounted for in the following manner:

Cash flow hedges: changes in fair value are recognized as a component in other comprehensive income.

Fair value hedges: changes in fair value are recognized concurrently in earnings.

Consistent with this guidance, as long as a hedging instrument is designated and the results of the effectiveness testing support that the instrument qualifies for hedge accounting treatment, 100% of the periodic changes in fair value of the hedging instrument are accounted for as outlined above. This is the case whether or not economic mismatches exist in the hedging relationship. As a result, there is no periodic measurement or recognition of ineffectiveness. Rather, the full impact of hedge gains and losses is recognized in the period in which the hedged transactions impact earnings.

While separate measurement and presentation of ineffectiveness is eliminated, paragraph 815-20-45-1A requires the change in fair value of the hedging instrument that is included in the assessment of hedge effectiveness be presented in the same income statement line item that is used to present the earnings effect of the hedged item.

Commitments to fund certain mortgage loans (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives.  These derivative contracts do not qualify for hedge accounting.  At March 31, 2020, the notional amount of the interest rate lock commitments was $371.6 million and forward commitments were $388.8 million.  At December 31, 2019, the notional amount of the interest rate lock commitments was $65.7 million and forward commitments were $101.6 million. It is our practice to enter into forward commitments for the future delivery of residential mortgage loans to third party investors when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitment to fund the loans.

Old National also enters into derivative instruments for the benefit of its customers.  The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $1.380 billion at March 31, 2020.  The notional amounts of these customer derivative instruments and the offsetting counterparty derivative instruments were $1.298 billion at December 31, 2019.  These derivative contracts do not qualify for hedge accounting.  These instruments include interest rate swaps, caps, and collars.  Commonly, Old National will economically hedge significant exposures related to these derivative contracts entered into for the benefit of customers by entering into offsetting contracts with approved, reputable, independent counterparties with substantially matching terms.

Old National enters into derivative financial instruments as part of its foreign currency risk management strategies.  These derivative instruments consist of foreign currency forward contracts to accommodate the business needs of its customers.  Old National does not designate these foreign currency forward contracts for hedge accounting treatment.  The notional amounts of these foreign currency forward contracts and the offsetting counterparty derivative instruments were $5.3 million at March 31, 2020 and $8.2 million at December 31, 2019.

Credit risk arises from the possible inability of counterparties to meet the terms of their contracts.  Old National’s exposure is limited to the replacement value of the contracts rather than the notional, principal, or contract

amounts.  There are provisions in our agreements with the counterparties that allow for certain unsecured credit exposure up to an agreed threshold.  Exposures in excess of the agreed thresholds are collateralized.  In addition, we minimize credit risk through credit approvals, limits, and monitoring procedures.

Amounts reported in AOCI related to cash flow hedges will be reclassified to interest income or interest expense as interest payments are received or paid on Old National’s derivative instruments.  During the next 12 months, we estimate that $6.7 million will be reclassified to interest income and $0.9 million will be reclassified to interest expense.

The following table summarizes the fair value of derivative financial instruments utilized by Old National:

(dollars in thousands)	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
March 31, 2020
Derivatives designated as hedging instruments
Interest rate contracts	Other assets	$	21,630	Other liabilities	$	1,443
Total derivatives designated as hedging instruments		$	21,630		$	1,443
Derivatives not designated as hedging instruments
Interest rate contracts (1)	Other assets	$	114,839	Other liabilities	$	26,630
Mortgage contracts	Other assets	13,081		Other liabilities	6,913
Foreign currency contracts	Other assets	323		Other liabilities	233
Total derivatives not designated as hedging instruments		$	128,243		$	33,776
Total		$	149,873		$	35,219
December 31, 2019
Derivatives designated as hedging instruments
Interest rate contracts	Other assets	$	7,157	Other liabilities	$	1,046
Total derivatives designated as hedging instruments		$	7,157		$	1,046
Derivatives not designated as hedging instruments
Interest rate contracts (1)	Other assets	$	42,224	Other liabilities	$	10,883
Mortgage contracts	Other assets	1,702		Other liabilities	354
Foreign currency contracts	Other assets	218		Other liabilities	110
Total derivatives not designated as hedging instruments		$	44,144		$	11,347
Total		$	51,301		$	12,393

(1)The fair values of counterparty interest rate swaps are zero due to the settlement of centrally-cleared variation margin rules.  The net adjustment was $88.9 million as of March 31, 2020 and $31.6 million as of December 31, 2019.

Summary information about the interest rate swaps designated as fair value hedges is as follows:

(dollars in thousands)	March 31, 2020			December 31, 2019
Notional amounts	$	380,500		$	130,500
Weighted average pay rates	0.33		%	1.82		%
Weighted average receive rates	1.33		%	2.20		%
Weighted average maturity (in years)	2.9			2.8
Fair value of swaps	$	10,797		$	1,555

The effect of derivative instruments in fair value hedging relationships on the consolidated statements of income were as follows:

(dollars in thousands)	Location of Gain or (Loss) Recognized in in Income on Derivative	Gain (Loss) Recognized in Income on Derivative		Hedged Items in Fair Value Hedging Relationships	Location of Gain or (Loss) Recognized in in Income on Related Hedged Item	Gain (Loss) Recognized in Income on Related Hedged Items
Derivatives in Fair Value Hedging Relationships
Three Months Ended March 31, 2020
Interest rate contracts	Interest income/(expense)	$	9,241	Fixed-rate debt	Interest income/(expense)	$	(9,228)
Three Months Ended March 31, 2019
Interest rate contracts	Interest income/(expense)	$	6,552	Fixed-rate debt	Interest income/(expense)	$	(6,548)

Summary information about the interest rate swaps designated as cash flow hedges is as follows: 

(dollars in thousands)	March 31, 2020			December 31, 2019
Notional amounts	$	125,000		$	25,000
Weighted average pay rates	1.11		%	3.52		%
Weighted average receive rates	1.46		%	1.93		%
Weighted average maturity (in years)	1.8			2.1
Unrealized gains (losses)	$	(1,443)		$	(954)

Old National has designated its interest rate collars as cash flow hedges.  The structure of these instruments is such that Old National pays the counterparty an incremental amount if the collar index exceeds the cap rate.  Conversely, Old National receives an incremental amount if the index falls below the floor rate.  No payments are required if the collar index falls between the cap and floor rates.  Summary information about the collars designated as cash flow hedges is as follows:

(dollars in thousands)	March 31, 2020			December 31, 2019
Notional amounts	$	300,000		$	300,000
Weighted average cap rates	3.21		%	3.21		%
Weighted average floor rates	2.21		%	2.21		%
Weighted average rates	1.25		%	1.70		%
Weighted average maturity (in years)	1.6			1.9
Unrealized gains (losses)	$	9,214		$	3,691

Old National has designated its interest rate floor transactions as cash flow hedges.  The structure of these instruments is such that Old National receives an incremental amount if the index falls below the floor strike rate. No payments are required if the index remains above the floor strike rate. Summary information about the interest rate floor transactions designated as cash flow hedges is as follows:

(dollars in thousands)	March 31, 2020
Notional amounts	$	100,000
Weighted average floor strike rate	0.75		%
Weighted average rates	0.99		%
Weighted average maturity (in years)	3.0
Unrealized gains (losses)	$	1,619

The structure of Old National's interest rate floor spread transactions at December 31, 2019 was such that Old National received an incremental amount if the index fell below the purchased floor strike rate.  Old National paid an incremental amount if the index fell below the sold floor rate.  Floor corridor protection was limited to the spread between the purchased floor strike rate and the sold floor rate.  No payments were required if the index remained above the purchased floor strike rate.  Old National terminated these interest rate floor spread transactions during the first quarter of 2020. Summary information about the floor spread transactions designated as cash flow hedges at December 31, 2019 was as follows:

(dollars in thousands)	December 31, 2019
Notional amounts	$	210,000
Weighted average purchased floor strike rate	2.00		%
Weighted average sold floor rate	1.00		%
Weighted average rate	1.70		%
Weighted average maturity (in years)	2.1
Unrealized gains (losses)	$	1,820

The effect of derivative instruments in cash flow hedging relationships on the consolidated statements of income were as follows:

		Three Months Ended March 31,				Three Months Ended March 31,
(dollars in thousands)		2020		2019		2020		2019
Derivatives in Cash Flow Hedging Relationships	Location of Gain or (Loss) Reclassified from AOCI into Income	Gain (Loss) Recognized in Other Comprehensive Income on Derivative				Gain (Loss) Reclassified from AOCI into Income
Interest rate contracts	Interest income/(expense)	$	7,803	$	(392)	$	431	$	385

The effect of derivatives not designated as hedging instruments on the consolidated statements of income were as follows:

		Three Months Ended March 31,
(dollars in thousands)		2020		2019
Derivatives Not Designated as Hedging Instruments	Location of Gain or (Loss) Recognized in Income on Derivative	Gain (Loss) Recognized in Income on Derivative
Interest rate contracts (1)	Other income/(expense)	$	(466)	$	(37)
Mortgage contracts	Mortgage banking revenue	4,820		1,022
Foreign currency contracts	Other income/(expense)	(19)		3
Total		$	4,335	$	988

(1)Includes the valuation differences between the customer and offsetting swaps.