Derivative Financial Instruments

Risk Management Objective of Using Derivatives

Webster is exposed to certain risks arising from both its business operations and economic conditions. Webster principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. Webster manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its debt funding and the use of derivative financial instruments. Specifically, Webster enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The type of hedge accounting designation used depends on the specific risk being hedged. Webster uses fair value hedges to mitigate changes in fair values due to fixed rates or prices while changes in cash flows due to variable rates or prices may be reduced or eliminated by a cash flow hedge.

Cash Flow Hedges of Interest Rate Risk

Webster’s primary objective in using interest rate derivatives is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, Webster uses interest rate swaps and caps as part of its interest rate risk management strategy. Interest rate swaps and caps designated as cash flow hedges are designed to manage the risk associated with a forecasted event or an uncertain variable rate cash flow.

Webster uses forward-settle interest rate swaps to protect the Company against adverse fluctuations in interest rates by reducing its exposure to variability in cash flows relating to interest payments on forecasted debt issuances. Forward-settle swaps are typically cash settled to coincide with a debt issuance. The change in fair value of the forward-settle swaps is recorded in OCI during the swap term. Upon termination, the OCI gain or loss at the time of debt issuance is amortized into interest expense over the life of the debt. There are no forward-settle swaps outstanding as of June 30, 2013.

Webster terminated two $25 million forward-settle interest rate swap hedge transactions, which qualified for cash flow hedge accounting in June 2013. The swap terminations were cash settled upon entering into a five-year FHLB advance effective June 28, 2013. The termination gain of $0.9 million was recorded in OCI and will be amortized into interest expense over the term of the advance maturing on July 2, 2018.

Previously terminated forward-settle swap losses have been recorded in OCI and will be amortized into earnings over the respective term of the associated debt instrument. At June 30, 2013, the remaining unamortized loss on the termination of cash flow hedges was $36.7 million. Over the next twelve months, the Company estimates that $8.6 million will be reclassified from OCI to interest expense. There was no hedge ineffectiveness for the three and six months ended June 30, 2013 and 2012.

The Company's $100 million interest rate swap which was designated as a cash flow hedge transaction matured on April 29, 2013, when the hedged FHLB advance matured.

The Company has two $25 million interest rate caps which are designated as cash flow hedge transactions against the risk of changes in cash flows related to the Company's $150 million 3-month LIBOR indexed floating rate FHLB advance maturing December 30, 2021. The caps each have a strike rate of 3.0% indexed to 3-month LIBOR. The change in fair value of the caps is marked through OCI and there is a $1.1 million gain as of June 30, 2013. The Company paid a $1.96 million premium, which will be reclassified from OCI to interest expense over the life of the cap according to a pre-determined caplet value schedule. Over the next twelve months, the amount to be reclassified is insignificant based on the caplet value schedule.

The table below presents the fair value of Webster’s derivative financial instruments designated as cash flow hedges as well as their classification in the accompanying Condensed Consolidated Balance Sheets:



		At June 30, 2013					At December 31, 2012
(Dollars in thousands)	Balance Sheet Classification	# of Instruments	Notional Amount		Estimated Fair Value		# of Instruments	Notional Amount		Estimated Fair Value
Interest rate derivatives designated as cash flow hedges:
Interest rate cap on FHLB advances	Other assets	2	$	50,000	$	3,056	—	$	—	$	—
Interest rate swap on FHLB advances	Other liabilities	—	$	—	$	—	1	$	100,000	$	(497	)
Forward-settle interest rate swap on anticipated debt	Other liabilities	—	—		—		4	100,000		(1,130		)

The net impact on interest expense related to cash flow hedges is presented below:



	Three months ended June 30,
	2013						2012
(In thousands)	Interest Expense		Deferred Loss (Gain)		Net Impact		Interest Expense		Deferred Loss (Gain)			Net Impact
Impact reported as an increase (reduction) in interest expense on borrowings:
Interest rate swaps on FHLB advances	$	118	$	1,519	$	1,637	$	336	$	1,139		$	1,475
Interest rate swaps on subordinated debt	—		—		—		—		(22		)	(22		)
Interest rate swaps on repurchase agreements	—		830		830		—		830			830
Interest rate swaps on Trust Preferred Securities	—		—		—		—		(44		)	(44		)
Net impact on interest expense on borrowings	$	118	$	2,349	$	2,467	$	336	$	1,903		$	2,239



	Six months ended June 30,
	2013								2012
(In thousands)	Interest Expense		Deferred Loss (Gain)			Net Impact			Interest Expense		Deferred Loss (Gain)			Net Impact
Impact reported as an increase (reduction) in interest expense on borrowings:
Interest rate swaps on FHLB advances	$	498	$	3,251		$	3,749		$	667	$	2,278		$	2,945
Interest rate swaps on subordinated debt	—		(3		)	(3		)	—		(49		)	(49		)
Interest rate swaps on repurchase agreements	—		1,660			1,660			—		1,299			1,299
Interest rate swaps on Trust Preferred Securities	—		—			—			—		(89		)	(89		)
Net impact on interest expense on borrowings	$	498	$	4,908		$	5,406		$	667	$	3,439		$	4,106

Fair Value Hedges of Interest Rate Risk

Webster is exposed to changes in the fair value of certain of its fixed-rate obligations due to changes in benchmark interest rates. Webster uses interest rate swaps to manage its exposure to changes in fair value on these obligations attributable to changes in the benchmark interest rate. Interest rate swaps designated as fair value hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for Webster making variable-rate payments over the life of the agreements without the exchange of the underlying notional amount. Webster did not have any derivative financial instruments designated as fair value hedges as of June 30, 2013 and December 31, 2012.

For derivatives designated and that qualify as fair value hedges, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, is recognized in interest expense. Webster includes the gain or loss from the period end mark to market (“MTM”) adjustments on the hedged items in the same line item as the offsetting gain or loss on the related derivatives. The impact of derivative net settlements, hedge ineffectiveness, basis amortization adjustments and amortization of deferred hedge terminations are also recognized in interest expense. At June 30, 2013, the remaining unamortized gain on the termination of fair value hedges was $2.7 million.

The net impact on interest expense related to fair value hedges is presented below:



	Three months ended June 30,
	2013										2012
(In thousands)	Interest Income		MTM Gain		Deferred Gain			Net Impact			Interest Income		MTM Gain		Deferred Gain			Net Impact
Impact reported as a (reduction) increase in interest expense on borrowings:
Interest rate swaps on senior notes	$	—	$	—	$	(800	)	$	(800	)	$	—	$	—	$	(800	)	$	(800	)
Interest rate swaps on subordinated debt	—		—		—			—			—		—		(620		)	(620		)
Net impact on interest expense on borrowings	$	—	$	—	$	(800	)	$	(800	)	$	—	$	—	$	(1,420	)	$	(1,420	)



	Six months ended June 30,
	2013										2012
(In thousands)	Interest Income		MTM Gain		Deferred Gain			Net Impact			Interest Income		MTM Gain		Deferred Gain			Net Impact
Impact reported as a (reduction) increase in interest expense on borrowings:
Interest rate swaps on senior notes	$	—	$	—	$	(1,599	)	$	(1,599	)	$	—	$	—	$	(1,599	)	$	(1,599	)
Interest rate swaps on subordinated debt	—		—		(207		)	(207		)	—		—		(1,407		)	(1,407		)
Net impact on interest expense on borrowings	$	—	$	—	$	(1,806	)	$	(1,806	)	$	—	$	—	$	(3,006	)	$	(3,006	)

Non-Hedge Accounting Derivatives / Non-designated Hedges

Derivatives that do not meet the hedge accounting requirements of ASC 815, “Derivatives and Hedging” are not speculative and are used to manage Webster’s exposure to interest rate movements and other identified risks. Changes in the fair value of these instruments are recorded as a component of non-interest income in the accompanying Condensed Consolidated Statements of Income.

Webster had the following outstanding interest rate swaps and caps that were not designated for hedge accounting:



		At June 30, 2013
					Estimated Fair Value
(Dollars in thousands)	Balance Sheet Classification	# of Instruments	Notional Amount		Gain		Loss			Net
Webster with customer position:
Commercial loan interest rate derivatives	Other assets	140	$	702,154	$	30,676	$	—		$	30,676
Commercial loan interest rate derivatives	Other liabilities	72	588,924		—		(10,200		)	(10,200		)
Total customer position		212	$	1,291,078	$	30,676	$	(10,200	)	$	20,476

Webster with counterparty position:
Commercial loan interest rate derivatives	Other assets	79	$	562,195	$	6,739	$	(3,173	)	$	3,566
Commercial loan interest rate derivatives	Other liabilities	126	728,624		8,673		(22,906		)	(14,233		)
Total counterparty position		205	$	1,290,819	$	15,412	$	(26,079	)	$	(10,667	)



		At December 31, 2012
					Estimated Fair Value
(Dollars in thousands)	Balance Sheet Classification	# of Instruments	Notional Amount		Gain		Loss			Net
Webster with customer position:
Commercial loan interest rate derivatives	Other assets	178	$	1,009,623	$	50,969	$	—		$	50,969
Commercial loan interest rate derivatives	Other liabilities	23	193,946		—		(124		)	(124		)
Total customer position		201	$	1,203,569	$	50,969	$	(124	)	$	50,845

Webster with counterparty position:
Commercial loan interest rate derivatives	Other liabilities	194	$	1,203,512	$	544	$	(41,965	)	$	(41,421	)
Total counterparty position		194	$	1,203,512	$	544	$	(41,965	)	$	(41,421	)

Webster reported the changes in the fair value of non-hedge accounting derivatives as a component of other non-interest income in the accompanying Condensed Consolidated Statements of Income as follows:



	Three months ended June 30,
	2013								2012
(In thousands)	Net Swap Income		MTM (Loss) Gain and Fees			Net Impact			Net Swap Income		MTM (Loss) Gain and Fees			Net Impact
Impact reported in other non-interest income:
Visa swap	$	—	$	(26	)	$	(26	)	$	—	$	(20	)	$	(20	)
Commercial loan interest rate derivatives, net	512		479			991			362		1,321			1,683
Fed funds futures contracts	—		108			108			—		61			61
Net impact on other non-interest income	$	512	$	561		$	1,073		$	362	$	1,362		$	1,724



	Six months ended June 30,
	2013								2012
(In thousands)	Net Swap Income		MTM (Loss) Gain and Fees			Net Impact			Net Swap Income		MTM (Loss) Gain and Fees			Net Impact
Impact reported in other non-interest income:
Visa swap	$	—	$	(51	)	$	(51	)	$	—	$	(472	)	$	(472	)
Commercial loan interest rate derivatives, net	997		687			1,684			677		2,100			2,777
Fed funds futures contracts	—		160			160			—		217			217
Net impact on other non-interest income	$	997	$	796		$	1,793		$	677	$	1,845		$	2,522

Offsetting Derivatives

Webster has entered into transactions with counterparties that are subject to an enforceable master netting agreement. In accordance with ASC 815, “Derivatives and Hedging”, and the recently adopted ASU 2013-01, the Company recognized those financial instruments subject to master netting agreements or similar agreements.

The tables below present the offsetting of financial assets and derivatives in the accompanying Condensed Consolidated Balance Sheets summarized by counterparty:



	At June 30, 2013
			Hedge Accounting Positions (1)				Non-Hedge Accounting Positions
(In thousands)	Notional Outstanding		Gain		Loss		Gain		Loss			Net Position (2)			Total Gain (Loss)			Cash Collateral			Net Exposure (3)
Counterparty:
Dealer A	$	367,672	$	—	$	—	$	4,797	$	(11,125	)	$	(6,328	)	$	(6,328	)	$	5,800		$	—
Dealer B	346,099		—		—		3,875		(10,205		)	(6,330		)	(6,330		)	5,160			—
Dealer C	14,853		—		—		1		(1,576		)	(1,575		)	(1,575		)	—			—
Dealer D	298,038		1,470		—		3,922		(562		)	3,360			4,830			(5,200		)	—
Dealer E	285,445		1,586		—		2,715		(2,611		)	104			1,690			(1,830		)	—
Dealer F	28,712		—		—		102		—			102			102			353			455
Total	$	1,340,819	$	3,056	$	—	$	15,412	$	(26,079	)	$	(10,667	)	$	(7,611	)	$	4,283



	At December 31, 2012
			Hedge Accounting Positions (1)					Non-Hedge Accounting Positions
(In thousands)	Notional Outstanding		Gain		Loss			Gain		Loss			Net Position (2)			Total Gain (Loss)			Cash Collateral		Net Exposure (3)
Counterparty:
Dealer A	$	561,716	$	—	$	(985	)	$	199	$	(16,721	)	$	(16,522	)	$	(17,507	)	$	17,900	$	393
Dealer B	403,097		—		(642		)	139		(15,281		)	(15,142		)	(15,784		)	16,980		1,196
Dealer C	15,221		—		—			1		(2,038		)	(2,037		)	(2,037		)	—		—
Dealer D	184,648		—		—			53		(2,506		)	(2,453		)	(2,453		)	2,600		147
Dealer E	238,830		—		—			152		(5,419		)	(5,267		)	(5,267		)	5,290		23
Total	$	1,403,512	$	—	$	(1,627	)	$	544	$	(41,965	)	$	(41,421	)	$	(43,048	)	$	42,770

(1) Hedge accounting positions are recorded on a gross basis in other assets (liabilities)

(2) Net gain (loss) position recorded in other assets (liabilities)

(3) Net positive exposure represents over collateralized loss positions which are the result of OTC clearing house initial margin requirements posted in compliance with Dodd-Frank regulations.

Counterparty Credit Risk. Derivative contracts involve the risk of dealing with both bank customers and institutional derivative counterparties and their ability to meet contractual terms. The Company has master International Swap Derivative Association ("ISDA") agreements with all derivative counterparties for non-cleared trades. Additionally, the Company has executed a Credit Support Annex ("CSA") to the master agreement with each of its institutional derivative counterparties. The ISDA master agreements provide that on each payment date all amounts otherwise owing the same currency under the same transaction are netted so that only a single amount is owed in that currency. The ISDA master agreements also provide, if the parties so elect, for such netting of amounts in the same currency among all transactions identified as being subject to such election that have common payment dates and booking offices. Under the CSA, daily net exposure in excess of our negotiated threshold is secured by posted cash collateral. The Company has adopted a zero threshold with the majority of its approved financial institution counterparties. In accordance with Webster policies, institutional counterparties must be analyzed and approved through the Company’s credit approval process.

The Company’s credit exposure on interest rate derivatives is limited to the net favorable value and interest payments of all derivatives by each of the counterparties for the amounts up to the established threshold for collateralization. Credit exposure may be reduced by the amount of collateral pledged by the counterparty. The Company's credit exposure related to derivatives with approved financial institutions is zero unless cash collateral exceeds the unfavorable market value.

Dodd-Frank derivative clearing rules became effective June 10, 2013 and require that initial margin be posted to the clearing houses for cleared derivative positions. In accordance with our CSA Agreements, approximately $11.3 million of collateral was pledged to financial counterparties and $7.0 million was received from financial counterparties at June 30, 2013. Collateral levels for approved financial institution counterparties are monitored on a daily basis and adjusted as necessary. In the event of default, should the collateral not be returned, the exposure would be offset by terminating the transactions.

The Company evaluates the credit risk of its counterparties, taking into account such factors as the likelihood of default, its net exposures, and remaining contractual life, among other things, in determining if any adjustments related to credit risk are required. The Company's net current credit exposure relating to interest rate derivatives with Webster Bank customers was $30.7 million at June 30, 2013. In addition, the Company monitors potential future exposure, representing our best estimate of exposure to remaining contractual maturity. The potential future exposure relating to interest rate derivatives with Webster Bank customers totaled $9.3 million at June 30, 2013. The credit exposure is mitigated as transactions with customers are secured by the collateral securing the underlying transaction being hedged. No losses on derivative instruments have occurred as a result of counterparty nonperformance.

Futures Contracts. On March 30, 2010, to hedge against a rise in short-term rates over the next twelve months, Webster entered into a $600 million short-selling of a one year strip of Fed funds future contracts with serial maturities between May 2010 and April 2011. Throughout 2010 and into 2013, Webster continued to roll the futures contracts but reduced the notional amount to $400 million beginning with the September 2011 contracts. Beginning in March 2013, the notional amounts were increased to $800 million. This transaction is designed to work in conjunction with floating rate assets with interest rate floors which will not be affected if there is an increase in short-term interest rates. The fair value of the contracts is a gain of $141 thousand and is reflected as other assets in the accompanying Condensed Consolidated Balance Sheets and the related income impact as non-interest income in the accompanying Condensed Consolidated Statements of Income. During the three and six months ended June 30, 2013 and 2012, the Company recognized $108 thousand and $160 thousand and $61 thousand and $217 thousand in mark to market gains, respectively. The Company had $580 thousand on deposit with counterparty as of June 30, 2013 to satisfy margin collateral requirements.

Mortgage Banking Derivatives. Certain derivative instruments, primarily forward sales of mortgage loans and MBS, are utilized by Webster in its efforts to manage risk of loss associated with its mortgage loan commitments and mortgage loans held for sale. Prior to closing and funding certain single-family residential mortgage loans, an interest rate lock commitment is generally extended to the borrower. During the period from commitment date to closing date, Webster 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, under which Webster agrees to deliver whole mortgage loans to various investors or issue MBS, are established. At June 30, 2013, outstanding rate locks totaled approximately $129.3 million and the outstanding commitments to sell residential mortgage loans totaled approximately $172.6 million. Forward sales, which include mandatory forward commitments of approximately $167.3 million at June 30, 2013, establish the price to be received upon the sale of the related mortgage loan, thereby mitigating certain interest rate risk. There is, however, still certain execution risk specifically related to Webster’s ability to close and deliver to its investors the mortgage loans it has committed to sell. The interest rate locked loan commitments and forward sales commitments are recorded at fair value, with changes in fair value recorded as non-interest income in the accompanying Condensed Consolidated Statements of Income. As of June 30, 2013 and December 31, 2012, the fair value of interest rate locked loan commitments and forward sales commitments totaled $5.1 million and $2.9 million, respectively, and were recorded as a component of other assets in the accompanying Condensed Consolidated Balance Sheets.

Foreign Currency Derivatives. The Company enters into foreign currency forward contracts that are not designated as hedging instruments, primarily to accommodate the business needs of its customers. Upon the origination of a foreign currency forward contract with a customer, the Company simultaneously enters into an offsetting contract with a third party to negate the exposure to fluctuations in foreign currency exchange rates. The notional amounts and fair values of open foreign currency forward contracts were not material at June 30, 2013 and December 31, 2012.