Derivative Financial Instruments

9 Months Ended

Sep. 30, 2012

Text Block [Abstract]

Derivative Financial Instruments

Derivative Financial Instruments

We primarily use derivative financial instruments to manage interest rate risk, currency exchange rate risk, and to assist customers with their risk management objectives. Also, in connection with negotiating credit facilities and certain other services, we often obtain equity warrant assets giving us the right to acquire stock in private, venture-backed companies in the technology and life science industries.

Interest Rate Risk

Interest rate risk is our primary market risk and can result from timing and volume differences in the repricing of our interest rate-sensitive assets and liabilities and changes in market interest rates. To manage interest rate risk for our 5.70% Senior Notes and 6.05% Subordinated Notes, we entered into fixed-for-floating interest rate swap agreements at the time of debt issuance based upon LIBOR with matched-terms. Prior to our termination of portions of our interest rate swap agreements (discussed below), we used the shortcut method to assess hedge effectiveness and evaluate the hedging relationships for qualification under the shortcut method requirements for each reporting period. Net cash benefits associated with our interest rate swaps were recorded as a reduction in “Interest expense—Borrowings,” a component of net interest income. The fair value of our interest rate swaps was calculated using a discounted cash flow method and adjusted for credit valuation associated with counterparty risk. Increases from changes in fair value were included in other assets and decreases from changes in fair value were included in other liabilities.

In connection with the repurchase of portions of our 5.70% Senior Notes and 6.05% Subordinated Notes in May 2011, we terminated corresponding amounts of the associated interest rate swaps. As a result of these terminations, the remaining portions of the interest rate swaps no longer qualify for the shortcut method to assess hedge effectiveness under ASC 815, Derivatives and Hedging, and are accounted for under the long-haul method. Any differences associated with our interest rate swaps that arise as a result of hedge ineffectiveness are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income. Our 5.70% Senior Notes matured and were repaid on June 1, 2012, at which time the remaining portion of the associated interest rate swap expired.

Currency Exchange Risk

We enter into foreign exchange forward contracts to economically reduce our foreign exchange exposure risk related to certain of our client loans that are denominated in foreign currencies, primarily in Pound Sterling and Euro. We do not designate any foreign exchange forward contracts as derivative instruments that qualify for hedge accounting. Changes in currency rates on the loans are included in other noninterest income, a component of noninterest income. We may experience ineffectiveness in the economic hedging relationship, because the loans are revalued based upon changes in the currency’s spot rate on the principal value, while the forwards are revalued on a discounted cash flow basis. We record forward agreements in gain positions in other assets and loss positions in other liabilities, while net changes in fair value are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income. Additionally, through our global banking operations we maintain customer deposits denominated in the Euro and Pound Sterling which are used to fund certain loans in these currencies to limit our exposure to currency fluctuations.

Other Derivative Instruments

Equity Warrant Assets

Our equity warrant assets are concentrated in private, venture-backed companies in the technology and life science industries. Most of these warrant agreements contain net share settlement provisions, which permit us to pay the warrant exercise price using shares issuable under the warrant (“cashless exercise”). We value our equity warrant assets using a modified Black-Scholes option pricing model, which incorporates assumptions about the underlying asset value, volatility, and the risk-free rate. We make valuation adjustments for estimated remaining life and marketability for warrants issued by private companies. Equity warrant assets are recorded at fair value in other assets, while changes in their fair value are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Loan Conversion Options

In connection with negotiating certain credit facilities, we occasionally extend loan facilities which have convertible option features. The convertible loans may be converted into a certain number of shares determined by dividing the principal amount of the loan by the applicable conversion price. Because our loan conversion options have underlying and notional values and had no initial net investment, these assets qualify as derivative instruments. We value our loan conversion options using a modified Black-Scholes option pricing model, which incorporates assumptions about the underlying asset value, volatility, and the risk-free rate. Loan conversion options are recorded at fair value in other assets, while changes in their fair value are recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Other Derivatives

We sell forward and option contracts to clients who wish to mitigate their foreign currency exposure. We economically reduce the currency risk from this business by entering into opposite way contracts with correspondent banks. This relationship does not qualify for hedge accounting. The contracts generally have terms of one year or less, although we may have contracts extending for up to five years. Generally, we have not experienced nonperformance on these contracts, have not incurred credit losses, and anticipate performance by all counterparties to such agreements. Increases from changes in fair value are included in other assets and decreases from changes in fair value are included in other liabilities. The net change in the fair value of these contracts is recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

We sell interest rate contracts to clients who wish to mitigate their interest rate exposure. We economically reduce the interest rate risk from this business by entering into opposite way contracts with correspondent banks. We do not designate any of these contracts (which are derivative instruments) as qualifying for hedge accounting. Increases from changes in fair value are included in other assets and decreases from changes in fair value are included in other liabilities. The net change in the fair value of these derivatives is recorded through net gains on derivative instruments, in noninterest income, a component of consolidated net income.

Counterparty Credit Risk

We are exposed to credit risk if counterparties to our derivative contracts do not perform as expected. We mitigate counterparty credit risk through credit approvals, limits, monitoring procedures and obtaining collateral, as appropriate. Consistent with the clarification guidance included in ASU 2011-4, we made an accounting policy decision effective January 1, 2012 to use the exception in the guidance with respect to measuring counterparty credit risk for derivative instruments, which allows us to continue to measure the fair value of a group of financial assets and financial liabilities on a net risk basis by counterparty portfolio.

The total notional or contractual amounts, fair value, collateral and net exposure of our derivative financial instruments at September 30, 2012 and December 31, 2011 were as follows:

		September 30, 2012										December 31, 2011
(Dollars in thousands)	Balance Sheet Location	Notional or Contractual Amount		Fair Value			Collateral (1)		Net Exposure (2)			Notional or Contractual Amount		Fair Value			Collateral (1)		Net Exposure (2)
Derivatives designated as hedging instruments:
Interest rate risks:
Interest rate swaps	Other assets	$	45,964	$	9,508		$	6,170	$	3,338		$	187,393	$	11,441		$	—	$	11,441
Derivatives not designated as hedging instruments:
Currency exchange risks:
Foreign exchange forwards	Other assets	23,441		548			—		548			68,518		514			—		514
Foreign exchange forwards	Other liabilities	38,593		(1,373		)	—		(1,373		)	6,822		(199		)	—		(199		)
Net exposure				(825		)	—		(825		)			315			—		315
Other derivative instruments:
Equity warrant assets	Other assets	162,471		70,478			—		70,478			144,586		66,953			—		66,953
Other derivatives:
Foreign exchange forwards	Other assets	419,005		11,581			—		11,581			387,714		17,541			—		17,541
Foreign exchange forwards	Other liabilities	393,426		(10,116		)	—		(10,116		)	366,835		(16,346		)	—		(16,346		)
Foreign currency options	Other assets	127,379		987			—		987			75,600		271			—		271
Foreign currency options	Other liabilities	127,379		(987		)	—		(987		)	75,600		(271		)	—		(271		)
Loan conversion options	Other assets	9,778		1,240			—		1,240			14,063		923			—		923
Client interest rate derivatives	Other assets	62,120		236			—		236			39,713		50			—		50
Client interest rate derivatives	Other liabilities	62,120		(247		)	—		(247		)	39,713		(52		)	—		(52		)
Net exposure				2,694			—		2,694					2,116			—		2,116
Net				$	81,855		$	6,170	$	75,685				$	80,825		$	—	$	80,825

(1) Cash collateral received from our counterparty for our interest rate swap agreement is recorded as a component of “short-term borrowings” on our consolidated balance sheets.

(2) Net exposure for contracts in a gain position reflects the replacement cost in the event of nonperformance by all such counterparties. The credit ratings of our institutional counterparties as of September 30, 2012 remain at investment grade or higher and there were no material changes in their credit ratings for the three and nine months ended September 30, 2012.

A summary of our derivative activity and the related impact on our consolidated statements of income for the three and nine months ended September 30, 2012 and 2011 is as follows:

		Three months ended September 30,						Nine months ended September 30,
(Dollars in thousands)	Statement of income location	2012			2011			2012			2011
Derivatives designated as hedging instruments:
Interest rate risks:
Net cash benefit associated with interest rate swaps	Interest expense—borrowings	$	612		$	2,337		$	4,537		$	12,205
Changes in fair value of interest rate swaps	Net gains on derivative instruments	74			(400		)	571			(467		)
Net gains associated with interest rate risk derivatives		$	686		$	1,937		$	5,108		$	11,738
Derivatives not designated as hedging instruments:
Currency exchange risks:
Gains (losses) on revaluations of foreign currency instruments	Other noninterest income	$	1,578		$	(3,931	)	$	96		$	(733	)
Gains on internal foreign exchange forward contracts, net	Net gains on derivative instruments	220			3,591			1,162			540
Net gains (losses) associated with currency risk		$	1,798		$	(340	)	$	1,258		$	(193	)
Other derivative instruments:
Gains on equity warrant assets	Net gains on derivative instruments	$	547		$	5,518		$	12,358		$	23,375
Gains on client foreign exchange forward contracts, net	Net gains on derivative instruments	$	607		$	658		$	3,002		$	1,448
Net (losses) gains on other derivatives (1)	Net gains on derivative instruments	$	(337	)	$	584		$	(1,293	)	$	(743	)

(1) Primarily represents the change in fair value of loan conversion options.