5. Derivatives

Risk Management Objective of Using Derivatives

The Company enters into derivative financial instruments to manage risks related to differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments, currently related to our variable rate borrowing. The Company has also entered into interest rate derivative agreements as a service provided to certain qualifying customers. The Company manages a matched book with respect to its customer derivatives in order to minimize its net risk exposure resulting from such agreements.

Fair Values of Derivative Instruments on the Balance Sheet

The Company has made an accounting policy election to use the exception in Accounting Standards Codification (ASC) 820-10-35-18D (commonly referred to as the “portfolio exception”) with respect to measuring counterparty credit risk for derivative instruments, consistent with the guidance in ASC 820-10-35-18G. The table below presents the fair value (in thousands) of the Company’s derivative financial instruments as well as their classification on the consolidated balance sheets as of September 30, 2012 and December 31, 2011.

Fair Values of Derivative Instruments


	Asset Derivatives						Liability Derivatives
	As of September 30, 2012			As of December 31, 2011			As of September 30, 2012			As of December 31, 2011
	Balance			Balance			Balance			Balance
	Sheet	Fair		Sheet	Fair		Sheet	Fair		Sheet	Fair
	Location	Value		Location	Value		Location	Value		Location	Value
Derivatives designated as hedging instruments
Interest rate products	Other assets	$	—	Other assets	$	—	Other liabilities	$	437	Other liabilities	$	107

Total derivatives designated as hedging instruments		$	—		$	—		$	437		$	107

Derivatives not designated as hedging instruments
Interest rate products	Other assets	$	21,198	Other assets	$	14,952	Other liabilities	$	21,986	Other liabilities	$	15,536

Total derivatives not designated as hedging instruments		$	21,198		$	14,952		$	21,986		$	15,536

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to decrease volatility in interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps. For hedges of the Company’s variable-rate borrowings, interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed payments. As of September 30, 2012, the Company had one interest rate swap with an aggregate notional amount of $140.0 million that was designated as a cash flow hedge of the Company’s forecasted variable cash flows under a variable-rate term loan agreement.

The effective portion of changes in the fair value of derivatives designated and qualifying as cash flow hedges is recorded in accumulated other comprehensive income (“AOCI”) and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The impact on AOCI was insignificant during 2011, and the impact of reclassifications on earnings during 2012 has been and is expected to continue to be insignificant. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. No hedge ineffectiveness was recognized during the three or nine months ended September 30, 2012. Amounts reported in AOCI related to these 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 $0.4 million will be reclassified as a decrease to interest expense.

Derivatives Not Designated as Hedges

The Company’s derivatives not designated as hedges result from a service the Banks provide to certain customers and are not speculative in nature. The Banks execute interest rate derivatives, primarily rate swaps, with commercial banking customers to facilitate their risk management strategies. The Banks simultaneously enters into offsetting agreements with unrelated financial institutions, thereby minimizing its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings. As of September 30, 2012, the Banks had entered into interest rate derivatives, including both customer and offsetting agreements, with an aggregate notional amount of $888.4 million related to this program.

Effect of Derivative Instruments on the Income Statement

The effect of the Company’s derivative financial instruments on the income statement was immaterial for the three and nine months ended September 30, 2012 and 2011.

Credit-risk-related Contingent Features

Certain of the Banks’ derivative instruments contain provisions allowing the financial institution counterparty to terminate the contracts in certain circumstances, such as the downgrade of the Banks’ credit ratings below specified levels, a default by the Bank on its indebtedness, or the failure of a Bank to maintain specified minimum regulatory capital ratios or its regulatory status as a well-capitalized institution. These derivative agreements also contain provisions regarding the posting of collateral by each party. As of September 30, 2012, the aggregate fair value of derivative instruments with credit-risk-related contingent features that were in a net liability position was $18.9 million, for which the Banks had posted collateral of $17.5 million.