Note 6. 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 Banks have also entered into interest rate derivative agreements as a service to certain qualifying customers. The Banks manage a matched book with respect to these customer derivatives in order to minimize their 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 December 31, 2012 and December 31, 2011.


Fair Values of Derivative Instruments
	Asset Derivatives						Liability Derivatives
	As of December 31, 2012			As of December 31, 2011			As of December 31, 2012			As of December 31, 2011
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Derivatives designated as hedging instruments
Interest rate products	Other assets	$	—	Other assets	$	—	Other liabilities	$	298	Other liabilities	$	107

Total derivatives designated as hedging instruments		$	—		$	—		$	298		$	107

Derivatives not designated as hedging instruments

Interest rate products	Other assets	$	20,093	Other assets	$	14,952	Other liabilities	$	20,802	Other liabilities	$	15,536

Total derivatives not designated as hedging instruments		$	20,093		$	14,952		$	20,802		$	15,536

Cash Flow Hedges of Interest Rate Risk

At both December 31, 2012 and 2011, the Company was party to an interest rate swap agreement with a notional amount of $140 million that was designated as a cash flow hedge of the Company’s forecasted variable cash flows under a variable-rate term borrowing agreement. The swap agreement expires in June 2013. Under the swap agreement, the Company receives interest on the notional amount at a variable rate and pays interest at a fixed rate. The Company’s objective is to decrease volatility in interest expense and to manage its exposure to interest rate movements.

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 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 $0.3 million will be reclassified as a decrease to interest expense.

Derivatives Not Designated as Hedges

Customer interest rate derivative program

The Banks enter into interest rate derivative agreements, primarily rate swaps, with commercial banking customers to facilitate their risk management strategies. The Banks simultaneously enter into offsetting agreements with unrelated financial institutions, thereby mitigating its net risk exposure resulting from such transactions. Because 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 December 31, 2012 and 2011, the aggregate notional value of interest rate contracts with customers was approximately $550 million and $290 million, respectively, with a like amount of offsetting agreements.

Mortgage banking derivatives

The Banks also enter into certain derivative agreements as part of their mortgage banking activities. These agreements include interest rate lock commitments on prospective residential mortgage loans and forward commitments to sell these loans to investors on a best efforts delivery basis. The aggregate notional amount of mortgage banking derivatives was $173 million at December 31, 2012 and $110 million at December 31, 2011. The fair value of mortgage banking derivatives was immaterial at both December 31, 2012 and 2011.

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 years ended December 31, 2012, 2011 and 2010.

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 December 31, 2012, the aggregate fair value of derivative instruments with credit-risk-related contingent features that were in a net liability position was $18.5 million, for which the Banks had posted collateral of $16.8 million.