DERIVATIVES AND HEDGING ACTIVITIES

The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives and foreign exchange contracts to accommodate the business requirements of its customers (“customer related positions”). The Company minimizes the market and liquidity risks of customer related positions by entering into similar offsetting positions with broker-dealers. Derivative instruments are carried at fair value in the Company’s financial statements. The accounting for changes in the fair value of a derivative instrument is dependent upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.

The Company does not enter into proprietary trading positions for any derivatives.

Interest Rate Positions

The Company currently utilizes interest rate swap agreements as hedging instruments against interest rate risk associated with the Company’s borrowings. An interest rate swap is an agreement whereby one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount, for a predetermined period of time, from a second party. The amounts relating to the notional principal amount are not actually exchanged. The maximum length of time over which the Company is currently hedging its exposure to the variability in future cash flows for forecasted transactions related to the payment of variable interest on existing financial instruments is six years.

The following table reflects the Company’s derivative positions for the periods indicated below for interest rate swaps which qualify as cash flow hedges for accounting purposes:



September 30, 2012
Notional Amount		Trade Date	Effective Date	Maturity Date	Receive (Variable) Index	Current Rate Received		Pay Fixed Swap Rate		Fair Value
(Dollars in Thousands)
$	25,000	16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.39	%	5.04	%	$	(4,715	)
25,000		16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.39	%	5.04	%	(4,716		)
25,000		8-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.41	%	2.65	%	(693		)
25,000		9-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.41	%	2.59	%	(676		)
25,000		9-Dec-08	10-Dec-08	10-Dec-18	3 Month LIBOR	0.41	%	2.94	%	(3,000		)
50,000		17-Nov-09	20-Dec-10	20-Dec-14	3 Month LIBOR	0.38	%	3.04	%	(2,980		)
25,000		5-May-11	10-Jun-11	10-Jun-15	3 Month LIBOR	0.41	%	1.71	%	(884		)
$	200,000									$	(17,664	)
December 31, 2011
Notional Amount		Trade Date	Effective Date	Maturity Date	Receive (Variable) Index	Current Rate Received		Pay Fixed Swap Rate		Fair Value
				(Dollars in Thousands)
$	25,000	16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.55	%	5.04	%	$	(4,745	)
25,000		16-Feb-06	28-Dec-06	28-Dec-16	3 Month LIBOR	0.55	%	5.04	%	(4,745		)
25,000		8-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.54	%	2.65	%	(941		)
25,000		9-Dec-08	10-Dec-08	10-Dec-13	3 Month LIBOR	0.54	%	2.59	%	(913		)
25,000		9-Dec-08	10-Dec-08	10-Dec-18	3 Month LIBOR	0.54	%	2.94	%	(2,349		)
50,000		17-Nov-09	20-Dec-10	20-Dec-14	3 Month LIBOR	0.56	%	3.04	%	(3,316		)
25,000		5-May-11	10-Jun-11	10-Jun-15	3 Month LIBOR	0.54	%	1.71	%	(704		)
40,000		18-Aug-11	2-Apr-12	10-Mar-19	3 Month LIBOR	TBD		1.89	%	(550		)
$	240,000									$	(18,263	)

During 2011, the Company had entered into a forward starting swap with a notional amount of $40 million, with the intention of hedging a future federal home loan advance. Subsequently, during the quarter ending March 31, 2012, the Company exited the forward starting swap. At the time of exit, the derivative instrument had a fair value of $22,000, which was received in cash and recognized in other income.

For derivative instruments that are designated and qualify as hedging instruments, the effective portion of the gains or losses is reported as a component of OCI, and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The Company expects approximately $5.7 million (pre-tax), to be reclassified to interest expense from OCI, related to the Company’s cash flow hedges in the next twelve months. This reclassification is due to anticipated payments that will be made and/or received on the swaps based upon the forward curve as of September 30, 2012.

The table below presents the net amortization income recognized as an offset to interest expense related to previously terminated swaps for the periods indicated:



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2012		2011		2012		2011
	(Dollars in Thousands)				(Dollars in Thousands)
NET AMORTIZATION INCOME	$	61	$	61	$	183	$	183

Customer Related Positions

Interest rate derivatives, primarily interest rate swaps, offered to commercial borrowers through the Bank’s loan level derivative program do not qualify as hedges for accounting purposes. The Bank believes that its exposure to commercial customer derivatives is limited because these contracts are simultaneously matched at inception with an offsetting dealer transaction. The commercial customer derivative program allows the Bank to retain variable-rate commercial loans while allowing the customer to synthetically fix the loan rate by entering into a variable-to-fixed interest rate swap.

Foreign exchange contracts offered to commercial borrowers through the Bank’s derivative program do not qualify as hedges for accounting purposes. The Bank acts as a seller and buyer of foreign exchange contracts to accommodate its customers. To mitigate the market and liquidity risk associated with these derivatives, the Bank enters into similar offsetting positions.

The following table reflects the Company’s customer related derivative positions for the periods indicated below for those derivatives not designated as hedging:



		Notional Amount Maturing
	# of Positions (1)	2012		2013	2014	2015	Thereafter	Total		Fair Value
	September 30, 2012
	(Dollars in Thousands)
LOAN LEVEL SWAPS:
Receive fixed, pay variable	137	$	—	17,374	65,939	107,243	278,381	$	468,937	$	30,691
Pay fixed, receive variable	131	$	—	17,374	65,939	107,243	278,381	$	468,937	$	(30,697	)
FOREIGN EXCHANGE CONTRACTS:
Buys foreign exchange, sells US currency	22	$	9,272	29,548	—	—	—	$	38,820	$	(1,120	)
Buys US currency, sells foreign exchange	22	$	9,272	29,548	—	—	—	$	38,820	$	1,149
	December 31, 2011
	(Dollars in Thousands)
LOAN LEVEL SWAPS:
Receive fixed, pay variable	101	$	—	19,197	80,234	112,458	171,533	$	383,422	$	24,478
Pay fixed, receive variable	101	$	—	19,197	80,234	112,458	171,533	$	383,422	$	(24,535	)
FOREIGN EXCHANGE CONTRACTS:
Buys foreign exchange, sells US currency	15	$	21,657	—	—	—	—	$	21,657	$	(1,081	)
Buys US currency, sells foreign exchange	15	$	21,657	—	—	—	—	$	21,657	$	1,098


(1)	The Company may enter into one swap agreement which offsets multiple reverse swap agreements. The positions will offset and the terms will be identical.

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet at the periods indicated:



	Asset Derivatives					Liability Derivatives
	Balance Sheet Location	Fair Value at September 30, 2012		Fair Value at December 31, 2011		Balance Sheet Location	Fair Value at September 30, 2012		Fair Value at December 31, 2011
	(Dollars in Thousands)
DERIVATIVES DESIGNATED AS HEDGES:
Interest rate swaps	Other Assets	$	—	$	—	Other Liabilities	$	17,664	$	18,263
DERIVATIVES NOT DESIGNATED AS HEDGES:
Customer Related Positions:
Loan level swaps	Other Assets	$	30,691	$	24,478	Other Liabilities	$	30,697	$	24,535
Foreign exchange contracts	Other Assets	1,149		1,098		Other Liabilities	1,120		1,081
TOTAL		$	31,840	$	25,576		$	31,817	$	25,616

The table below presents the effect of the Company’s derivative financial instruments included in OCI and current earnings for the periods indicated:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
	(Dollars in Thousands)						(Dollars in Thousands)
DERIVATIVES DESIGNATED AS HEDGES:
Loss in OCI on Derivative (Effective Portion), Net of Tax	$	(929	)	$	(4,110	)	$	(2,125	)	$	(6,518	)
Loss Reclassified from OCI into Interest Expense (Effective Portion):	$	(1,370	)	$	(1,467	)	$	(4,008	)	$	(4,065	)
Loss Recognized in Income on Derivative
(Ineffective Portion & Amount Excluded from Effectiveness Testing):
Interest Expense	$	—		$	—		$	—		$	—
Other Expense	—			—			—			—
TOTAL	$	—		$	—		$	—		$	—
DERIVATIVES NOT DESIGNATED AS HEDGES:
Changes in Fair Value of Customer Related Positions:
Other Income	$	12		$	52		$	85		$	122
Other Expense	(4		)	—			(23		)	(17		)
TOTAL	$	8		$	52		$	62		$	105

Derivative contracts involve the risk of dealing with derivative counterparties and their ability to meet contractual terms. Institutional counterparties must have an investment grade credit rating and be approved by the Company’s Board of Directors. The Company’s credit exposure on interest rate swaps is limited to the net positive fair value and accrued interest of all swaps with each counterparty. The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company fails to maintain its status as a well capitalized institution, then the Company could be required to terminate any outstanding derivatives with the counterparty. The Company had no exposure relating to interest rate swaps with institutional counterparties at September 30, 2012 and December 31, 2011, as all such swaps were in a liability position. The Company’s exposure relating to customer related positions was approximately $31.2 million and $25.1 million at September 30, 2012 and December 31, 2011, respectively. Credit exposure may be reduced by the amount of collateral pledged by the counterparty.

The Company currently holds derivative instruments that contain credit-risk related contingent features that are in a net liability position, which require the Company to assign collateral. The table below presents information relating to credit-risk contingent instruments as of the dates indicated:



	September 30, 2012		December 31, 2011
	(Dollars in Thousands)
NOTIONAL AMOUNT	$	668.9	$	623.4
AGGREGATE FAIR VALUE	$	48.4	$	42.8
COLLATERAL ASSIGNED	$	50.3	$	47.6

Collateral legally required to be maintained at dealer banks by the Company is monitored and adjusted as necessary. Per a review completed by management of these instruments at September 30, 2012 it was determined that no additional collateral would have to be posted to immediately settle these instruments.

The Company does not offset fair value amounts recognized for derivative instruments. The Company does net the amount recognized for the right to reclaim cash collateral against the obligation to return cash collateral arising from derivative instruments executed with the same counterparty under a master netting arrangement.

Mortgage Derivatives

Forward sale contracts of residential mortgage loans, considered derivative instruments for accounting purposes, are utilized by the Company in its efforts to manage risk of loss associated with its mortgage loan commitments and mortgage loans intended for sale. Prior to closing and funding certain one-to-four family residential mortgage loans, an interest rate lock commitment is generally extended to the borrower. During the period from commitment date to closing date, the Company is subject to the risk that market rates of interest may change. If market rates rise, investors generally will pay less to purchase such loans resulting in a reduction in the gain on sale of the loans or, possibly, a loss. In an effort to mitigate such risk, forward delivery sales commitments are executed, under which the Company agrees to deliver whole mortgage loans to various investors. The interest rate lock commitments and forward sales commitments are recorded at fair value, with changes in fair value recorded in current period earnings as a component of mortgage banking income. The Company elects to carry newly originated closed loans held for sale at fair value. The Company has chosen to carry these at fair vale as changes in the fair value marks on loans held for sale offset changes in interest rate lock and forward sales commitments. The change in fair value of loans held for sale is recorded in current period earnings as a component of mortgage banking income.

The table below summarizes the fair value of residential mortgage loans commitments, forward sales agreements, and loans held for sale at the periods indicated:



	September 30, 2012			December 31, 2011
	(Dollars in Thousands)
INTEREST RATE LOCK COMMITMENTS	$	831		$	265
FORWARD SALES AGREEMENTS	$	(1,882	)	$	(528	)
LOANS HELD FOR SALE FAIR VALUE ADJUSTMENTS	$	1,051		$	263

The table below summarizes the changes in the fair value of residential mortgage loans commitments, forward sales agreements, and loans held for sale at the periods indicated:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
	(Dollars in Thousands)						(Dollars in Thousands)
INTEREST RATE LOCK COMMITMENTS	$	465		$	468		$	566		$	900
FORWARD SALES AGREEMENTS	(1,141		)	(750		)	(1,354		)	(1,829		)
LOANS HELD FOR SALE FAIR VALUE ADJUSTMENT	676			282			788			929
TOTAL CHANGE IN FAIR VALUE	$	—		$	—		$	—		$	—