NOTE 16: 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. Webster's derivative financial instruments are used to manage differences in the amount, timing, and duration of Webster's known or expected cash receipts and its known or expected cash payments principally related to its investments and borrowings.

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 as part of its interest rate risk management strategy. Interest rate swaps 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-starting 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. All forward settle swaps are expected to be cash settled at debt issuance. The change in fair value of the forward settle swaps are marked through OCI and the OCI gain or loss at the time of debt issuance will be amortized over the life of the debt. The valuation balance recorded in OCI related to future settle cash flow swaps was a net $15.0 million loss as of December 31, 2011.

During July 2011, Webster entered into six $25 million forward settle interest rate swap hedges which qualify for cash flow hedge accounting. The swaps were terminated upon entering into a ten-year FHLB Advance effective December 28, 2011. The swaps were terminated at a loss of $16.2 million and the loss will be amortized from OCI to earnings over the term of the advance maturing on December 30, 2021.

During May 2011, Webster entered into two $50 million forward settle interest rate swap hedges which qualify for cash flow hedge accounting. The swaps protect the Company against adverse fluctuations in interest rates by reducing exposure to variability in cash flows related to interest payments on forecasted issuance of six-year debt. Each $50 million swap pays fixed rates and receives 1-month LIBOR indexed floating rates, effective on September 5, 2012 and September 11, 2012 and maturing on June 5, 2018 and June 11, 2018. Cash settlement is expected to occur on the effective date and the forecasted six-year debt issuances are expected to occur between June 11, 2012 and December 11, 2012.

During March 2011, Webster entered into two $50 million forward settle interest rate swap hedges which qualify for cash flow hedge accounting. The swaps protect the Company against adverse fluctuations in interest rates by reducing exposure to variability in cash flows related to interest payments on forecasted issuances of four-year debt. Each swap pays fixed rates and receives 3-month LIBOR indexed floating rates, effective on March 15, 2012 and maturing on March 15, 2016. Cash settlement is expected to occur on the effective date and the forecasted four-year debt issuances are expected to occur between December 15, 2011 and June 15, 2012.

During July 2010, Webster entered into a $100 million forward settle interest rate swap which qualifies for cash flow hedge accounting. The swap was terminated and the related five-year FHLB Advance occurred on September 8, 2011. The swap was terminated at a loss of $7.3 million and the loss will be amortized from OCI to earnings over the term of the advances maturing on September 12, 2016. During the year ended December 31, 2011, $486.0 thousand of the loss was recognized in earnings.

The Company has a $100 million swap designated as a cash flow hedge transaction against the risk of changes in cash flows related to the Company's $100 million 3-month LIBOR indexed floating rate FHLB advance maturing April 29, 2013. The swap's change in fair value is marked through OCI and a component of OCI is reclassified to expense on a quarterly basis. The balance in OCI related to this cash flow hedge is a $1.5 million loss as of December 31, 2011.

Amounts reported in OCI related to current cash flow derivatives will be reclassified to interest expense as interest payments are made on the Company's variable-rate debt. During the next twelve months, the Company estimates that $3.4 million will be reclassified as an increase to interest expense. In addition, over the next twelve months the Company will reclassify $6.1 million from OCI as an increase to interest expense related to amortization of net losses related to termination of cash flow hedges.

The table below presents the fair value of Webster's derivative financial instruments designated as cash flow hedges as well as their classification on the Consolidated Balance Sheets as of December 31, 2011 and 2010.


					December 31, 2011							December 31, 2010
(Dollars in thousands)	Consolidated Balance Sheet Location		# of Instruments		Notional Amount		Estimated Fair Value			# of Instruments		Notional Amount		Estimated Fair Value
Interest rate derivatives designated as hedges of cash flow:
Interest rate swap on FHLB advances		Other liabilities		1	$	100,000	$	(1,521	)		1	$	100,000	$	(2,050	)
Forward settle interest rate swap on anticipated debt		Other liabilities		4		200,000		(15,050	)		1		100,000		(4,158	)
Forward settle interest rate swap on anticipated debt		Other assets		0		—		—			1		100,000		186

The net impact on interest expense related to cash flow hedges for the years ended December 31, 2011, 2010 and 2009 is presented below:


	Years ended December 31,
	2011								2010								2009
	Interest Expense		Realized Deferred Loss (Gain)			Net Impact			Interest Expense		Realized Deferred Loss (Gain)			Net Impact			Interest Expense		Realized Deferred Loss (Gain)			Net Impact
Impact reported as an increase or (reduction) in interest expense on borrowings
Interest rate swaps on FHLB advances	$	1,542	$	1,962		$	3,504		$	1,113	$	1,476		$	2,589		$	656	$	984		$	1,640
Interest rate swaps on subordinated debt		—		(150	)		(150	)		—		(150	)		(150	)		—		(227	)		(227	)
Interest rate swaps on repurchase agreement		—		1,095			1,095			—		—			—			—		—			—
Interest rate swaps on Trust Preferred Securities		—		(180	)		(180	)		—		(180	)		(180	)		—		(896	)		(896	)

Net impact on interest expense on borrowings	$	1,542	$	2,727		$	4,269		$	1,113	$	1,146		$	2,259		$	656	$	(139	)	$	517

At December 31, 2011, the remaining unamortized loss on the termination of cash flow hedges was $28.4 million.

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 instruments 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.

The table below presents the fair value of Webster's derivative financial instruments designated as fair value hedges as well as their classification on the Consolidated Balance Sheets as of December 31, 2011 and 2010.

Consolidated

Balance Sheet

Location

# of
Instruments

December 31, 2011

# of
Instruments

December 31, 2010

Notional
Amount

Estimated
Fair Value

Notional
Amount

Estimated
Fair Value

(Dollars in thousands)

Interest rate derivatives designated as hedges of fair value:

Interest rate swap on FHLB advances

Other
assets

—

100,000

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 earnings. 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 loss or gain on the related derivatives. The impacts of derivative net settlements, hedge ineffectiveness, basis amortization adjustments and amortization of deferred hedge terminations are also recognized in earnings.

The net impact on interest expense related to fair value hedges is presented below for the periods indicated:


	Years ended December 31,
	2011												2010												2009
	Interest Income			MTM Gain			Realized Deferred (Gain) Loss			Net Impact			Interest Income			MTM Gain			Realized Deferred (Gain) Loss			Net Impact			Interest Income			MTM (Gain) Loss			Realized Deferred (Gain) Loss			Net Impact
Impact reported as a (reduction) or increase in interest expense on borrowings
Interest rate swaps on senior notes	$	—		$	—		$	(3,197	)	$	(3,197	)	$	—		$	—		$	(3,197	)	$	(3,197	)	$	(4,134	)	$	(728	)	$	(132	)	$	(4,994	)
Interest rate swaps on subordinated debt		—			—			(4,479	)		(4,479	)		(497	)		(94	)		(4,087	)		(4,678	)		(5,801	)		103			(40	)		(5,738	)
Interest rate swaps on FHLB advances		(61	)		(144	)		34			(171	)		(708	)		(1,600	)		1,321			(987	)		(704	)		(149	)		453			(400	)

Net impact on interest expense on borrowings	$	(61	)	$	(144	)	$	(7,642	)	$	(7,847	)	$	(1,205	)	$	(1,694	)	$	(5,963	)	$	(8,862	)	$	(10,639	)	$	(774	)	$	281		$	(11,132	)

At December 31, 2011, the remaining unamortized gain on the termination of fair value hedges was $12.1 million.

Non-Hedge Accounting Derivatives / Non-designated Hedges

Derivatives not designated as hedges for accounting are not speculative and are used to manage Webster's exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of FASB ASC 815, "Derivatives and Hedging". Changes in the fair value of these instruments are recorded as a component of non-interest income. As of December 31, 2011 and 2010, Webster had the following outstanding interest rate swaps and caps that were not designated for hedge accounting:


	Consolidated Balance Sheet Location		At December 31,
			2011							2010
(Dollars in thousands)			# of Instruments		Notional Amount		Estimated Fair Value			# of Instruments		Notional Amount		Estimated Fair Value
Webster with customer position:
Commercial loan interest rate swaps		Other assets		127	$	615,773	$	45,140			98	$	447,689	$	33,890
Commercial loan interest rate swaps		Other liabilities		0		—		—			2		30,542		(990	)
Commercial loan interest rate swaps with floors		Other assets		12		25,217		1,994			12		28,342		1,060
Commercial loan interest rate caps		Other liabilities		13		119,186		(160	)		5		19,164		(83	)
Webster with counterparty position:
Commercial loan interest rate swaps		Other liabilities		119		595,542		(40,269	)		92		429,290		(31,394	)
Commercial loan interest rate swaps		Other liabilities		4		20,180		13			7		48,895		1,362
Commercial loan interest rate swaps with floors		Other liabilities		12		25,217		(1,597	)		12		28,342		(625	)
Commercial loan interest rate caps		Other liabilities		13		119,186		160			5		19,164		98

Webster reported the changes in the fair value of non-hedge accounting derivatives as a component of other non-interest income in the accompanying consolidated statements of operations as follows for the years ended December 31, 2011, 2010 and 2009.


	Years ended December 31,
	2011								2010								2009
	Interest Income		MTM (Loss) Gain			Net Impact			Interest Income		MTM (Loss) Gain			Net Impact			Interest Income		MTM (Loss) Gain			Net Impact
Impact reported in other non-interest income:
Visa Swap	$	—	$	(153	)	$	(153	)	$	—	$	(330	)	$	(330	)	$	—	$	(194	)	$	(194	)
Commercial loan interest rate derivatives, net		927		1,962			2,889			708		686			1,394			681		135			816
Fed funds futures contracts		—		(1,815	)		(1,815	)		—		(2,462	)		(2,462	)		—		—			—

Net impact on other non-interest income	$	927	$	(6	)	$	921		$	708	$	(2,106	)	$	(1,398	)	$	681	$	(59	)	$	622

The weighted average rates paid and received for interest rate swaps outstanding at December 31, 2011 were as follows:


	Weighted-Average
	Interest Pay Coupon			Interest Receive Coupon
Interest rate swaps:
Cash flow hedge interest rate swaps		1.85	%		0.46	%
Non-hedging interest rate swaps		1.65	%		1.74	%

The weighted average strike rates for interest rate caps and floors outstanding at December 31, 2011 were as follows:


	Strike Rate
Non-hedging commercial loan interest rate caps		2.98	%
Non-hedging commercial loan interest rate floors (embedded in interest rate swaps)		0.99

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 2011, Webster continued to roll the futures contracts but reduced the notional amount to $400 million for the September 2011 through April 2013 contracts. 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 contracts is reflected as other liabilities on the Condensed Consolidated Balance Sheets and the related income statement impact as non-interest income on the Consolidated Statement of Operations. During the years ended December 31, 2011 and 2010, the Company recognized $1.8 million and $2.5 million, respectively, in mark to market losses.

Mortgage Banking Derivatives. Certain derivative instruments, primarily forward sales of mortgage loans and mortgage-backed securities ("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 locked 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 December 31, 2011, outstanding rate locks totaled approximately $116.3 million and the outstanding commitments to sell residential mortgage loans totaled approximately $134.1 million. Forward sales, which include mandatory forward commitments of approximately $133.0 million at December 31, 2011, 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 on the Consolidated Statement of Operations. As of December 31, 2011, the fair value of interest rate locked loan commitments and forward sales commitments totaled $0.2 million and were recorded as a component of other assets in the accompanying Consolidated Balance Sheets. As of December 31, 2010, the fair value of interest rate locked loan commitments and forward sales commitments totaled $1.9 million and were recorded as a component of other assets in the accompanying 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 December 31, 2011 and 2010.

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 ISDA agreements with all derivative counterparties. 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 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 fully underwritten and approved through the Company's credit approval process. The Company's credit exposure on interest rate swaps is limited to the net favorable value and interest payments of all swaps by each counterparty 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 relating to interest rate swaps with bank customers was approximately $47.1 million at December 31, 2011. This credit exposure is partly mitigated as transactions with customers are secured by the collateral, if any, securing the underlying transaction being hedged. The Company's credit exposure related to derivatives with approved financial institutions is zero as the positions each have a net unfavorable market value. In accordance with our CSA Agreements, approximately $65.0 million of collateral was pledged to those counterparties at December 31, 2011. 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.