Derivative Financial Instruments

6 Months Ended

Jun. 30, 2012

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities Disclosure

DERIVATIVE FINANCIAL INSTRUMENTS

Heartland uses derivative financial instruments as part of its interest rate risk management strategy, including interest rate swaps, caps, floors and collars and certain interest rate lock commitments and forward sales of securities related to mortgage banking activities. Heartland's objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amounts to be exchanged between the counterparties. Heartland is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. Heartland minimizes this risk by entering into derivative contracts with large, stable financial institutions. Heartland has not experienced any losses from nonperformance by these counterparties. Heartland monitors counterparty risk in accordance with the provisions of ASC 815. In addition, interest rate-related derivative instruments generally contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. Heartland was required to pledge $7.7 million and $6.3 million of cash as collateral at June 30, 2012, and December 31, 2011, respectively.

Heartland's derivative and hedging instruments are recorded at fair value on the consolidated balance sheets. See Note 8, “Fair Value,” for additional fair value information and disclosures.

Cash Flow Hedges

Heartland has variable rate funding which creates exposure to variability in interest payments due to changes in interest rates. To manage the interest rate risk related to the variability of interest payments, Heartland has entered into various interest rate swap agreements. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received or made on Heartland's variable-rate liabilities. For the six months ended June 30, 2012, the change in net unrealized losses on cash flow hedges reflects changes in the fair value of the swaps and reclassification from accumulated other comprehensive income to interest expense totaling $985 thousand. For the next twelve months, Heartland estimates that cash payments and reclassification from accumulated other comprehensive income to interest expense will total $2.0 million.

Heartland executed an interest rate swap transaction on April 5, 2011, with an effective date of April 20, 2011, and an expiration date of April 20, 2016, to effectively convert $15.0 million of its newly issued variable rate amortizing debt to fixed rate debt. For accounting purposes, this swap transaction is designated as a cash flow hedge of the changes in cash flows attributable to changes in one-month LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on an amount of Heartland's debt principal equal to the then-outstanding swap notional amount. At inception, Heartland asserted that the underlying principal balance would remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swap.

During the first quarter of 2009, Heartland entered into three forward-starting interest rate swap transactions to effectively convert $65.0 million of its variable interest rate subordinated debentures (issued in connection with the trust preferred securities of Heartland Financial Statutory Trust IV, V and VII) to fixed interest rate debt. For accounting purposes, these three swap transactions are designated as cash flow hedges of the changes in cash flows attributable to changes in LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on $65.0 million of Heartland's subordinated debentures (issued in connection with the trust preferred securities of Heartland Financial Statutory Trust IV, V and VII) that reset quarterly on a specified reset date. At inception, Heartland asserted that the underlying principal balance would remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.

The table below identifies the balance sheet category and fair values of Heartland's derivative instruments designated as cash flow hedges at June 30, 2012, and December 31, 2011, in thousands:

	Notional Amount		Fair Value			Balance Sheet Category	Receive Rate		Weighted Average Pay Rate		Maturity
June 30, 2012
Interest rate swap	$	13,620	$	(769	)	Other Liabilities	2.993	%	5.140	%	4/20/2016
Interest rate swap	25,000		(900		)	Other Liabilities	0.468	%	2.580	%	3/17/2014
Interest rate swap	20,000		(2,214		)	Other Liabilities	0.467	%	3.220	%	3/1/2017
Interest rate swap	20,000		(2,990		)	Other Liabilities	0.469	%	3.355	%	1/7/2020
December 31, 2011
Interest rate swap	$	14,221	$	(725	)	Other Liabilities	3.035	%	5.140	%	4/20/2016
Interest rate swap	25,000		(1,032		)	Other Liabilities	0.559	%	2.580	%	3/17/2014
Interest rate swap	20,000		(2,064		)	Other Liabilities	0.527	%	3.220	%	3/1/2017
Interest rate swap	20,000		(2,584		)	Other Liabilities	0.384	%	3.355	%	1/7/2020

The table below identifies the gains and losses recognized on Heartland's derivative instruments designated as cash flow hedges for the six months ended June 30, 2012, and June 30, 2011, in thousands:

	Effective Portion							Ineffective Portion
	Recognized in OCI			Reclassified from AOCI into Income				Recognized in Income on Derivatives
	Amount of Gain(Loss)			Category	Amount of Gain(Loss)			Category	Amount of Gain(Loss)
June 30, 2012
Interest rate swap	$	(44	)	Interest Expense	$	(151	)	Other Income	$	—
Interest rate swap	132			Interest Expense	(262		)	Other Income	—
Interest rate swap	(150		)	Interest Expense	(276		)	Other Income	—
Interest rate swap	(406		)	Interest Expense	(296		)	Other Income	—
June 30, 2011
Interest rate swap	$	(98	)	Interest Expense	$	(287	)	Other Income	$	—
Interest rate swap	(272		)	Interest Expense	(295		)	Other Income	—
Interest rate swap	(295		)	Interest Expense	(309		)	Other Income	—

Economic Hedges

Heartland has certain derivative contracts which are accounted for as economic hedges. These contracts do not qualify for hedge accounting. These contracts are carried on the balance sheet at fair value with changes in fair value recorded as a component of other noninterest expense on the consolidated statements of income.

To reduce the potentially negative impact an upward movement in interest rates would have on its net interest income, Heartland entered into two cap transactions. For accounting purposes, these two cap transactions were designated as cash flow hedges of the changes in cash flows attributable to changes in LIBOR, the benchmark interest rate being hedged, above the cap strike rate associated with the hedged interest payments made on $40 million of Heartland's subordinated debentures that reset quarterly on a specified reset date.

The first transaction, executed on January 15, 2008, was a fifty-five month interest rate cap on a notional amount of $20.0 million. The cap had an effective date of January 15, 2008 and a maturity date of September 1, 2012. Should 3-month LIBOR exceed 5.12% on a reset date, the counterparty will pay Heartland the amount of interest that exceeds the amount owed on the debt at the cap LIBOR rate of 5.12%. The floating rate subordinated debentures contain an interest rate deferral feature that is mirrored in the cap transaction. Heartland executed an interest rate swap transaction on February 4, 2009, and converted this cap transaction into an economic hedge and hedge accounting for the cap transaction was ceased.

The second transaction, executed on March 27, 2008, was a twenty-eight month interest rate cap transaction on a notional amount of $20.0 million. The cap had an effective date of January 7, 2009, and a maturity date of April 7, 2011. When 3-month LIBOR exceeded 5.50% on a reset date, the counterparty paid Heartland the amount of interest that exceeds the amount owed on the debt at the cap LIBOR rate of 5.50%. The floating rate subordinated debentures contain an interest rate deferral feature that was mirrored in the cap transaction.

Mortgage Derivatives

Heartland also has entered into interest rate lock commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans and mortgage backed securities that are considered derivative instruments. The fair value of these commitments is recorded on the consolidated balance sheets with the changes in fair value recorded in the consolidated statements of income as a component of gains on sale of loans held for sale. These derivative contracts are designated as free standing derivative contracts and are not designated against specific assets and liabilities on the balance sheet or forecasted transactions and therefore do not qualify for hedge accounting treatment.

The table below identifies the balance sheet category and fair values of Heartland's derivative instruments not designated as hedging instruments at June 30, 2012, and December 31, 2011, in thousands:

	Notional Amount		Fair Value			Balance Sheet Category
June 30, 2012
Interest rate lock commitments (mortgage)	$	316,351	$	11,011		Other Assets
Interest rate cap	20,000		—			Other Assets
Forward commitments	53,326		214			Other Assets
Forward commitments	316,571		(3,217		)	Other Liabilities
December 31, 2011
Interest rate lock commitments (mortgage)	$	113,438	$	3,697		Other Assets
Interest rate cap	20,000		—			Other Assets
Forward commitments	91,750		(869		)	Other Assets

The table below identifies the income statement category of the gains and losses recognized in income on Heartland's derivative instruments not designated as hedging instruments for the six months ended June 30, 2012, and June 30, 2011, in thousands :

	Income Statement Category	Year-to-Date Gain(Loss) Recognized
June 30, 2012
Interest rate lock commitments (mortgage)	Gains on Sale of Loans Held for Sale	$	11,011
Interest rate cap	Other Income	—
Forward commitments	Gains on Sale of Loans Held for Sale	(3,003		)
June 30, 2011
Interest rate cap	Other Income	—
Interest rate cap	Other Income	(4		)