Annual Report - CoBank

Fair Value HedgesThe majority of the fair value hedging activity relates toentering into interest rate swaps primarily to convert our nonprepayablefixed-rate debt to floating-rate debt to achieve ourliquidity management strategy. The amount converted dependson contractual interest rates and maturities. For the remainingfair value hedges, we enter into receive-fixed, pay-floatingswaps to align our equity positioning strategy with our riskmanagement strategy. For fair value hedges, the amount ofhedge ineffectiveness is recognized as net interest income incurrent period earnings.Cash Flow HedgesWe purchase interest rate caps to hedge cap riskembedded within a portion of our floating-rate investmentsecurities. The interest rate caps hedge floating-rate debt cashflows that fund the cash flows from floating-rate investmentsecurities. If the strike rates in the purchased interest rate capsare exceeded, we receive cash flows on the derivative to hedgeour floating-rate funding exposure above such strike levels.We also enter into foreign exchange spot and forwardcontracts to manage currency risk on loans denominated inforeign currencies. Typically, foreign currency contracts arepurchased to fund the principal cash flows of the loan andsimultaneously sold to lock in the principal and interest cashflows upon repricing or maturity date of the loan. For cashflow hedges, the amount of hedge ineffectiveness, the amountexcluded from effectiveness assessment, and the amountsreclassified from accumulated other comprehensive income(loss) into current period earnings are all reflected in netinterest income. At December 31, 2011, we expect that$1.5 million of expense will be reclassified from othercomprehensive income into the income statement in the next12 months, based on the anticipated cash flows of existingfinancial instruments. The maximum term over which we arehedging our exposure to the variability of future cash flows forall forecasted transactions is approximately five years.Derivatives Not Designated As HedgesDerivative agreements with our customers and the relatedoffsetting derivative agreements with counterparties are notdesignated as hedging instruments and do not receive hedgeaccounting treatment. Accordingly, any changes in the fairvalue of these customer related derivatives are recognizedimmediately as noninterest income/expense in current periodearnings.Counterparty Credit RiskThe use of derivatives for risk management introducescredit risk related to counterparties and market risk related tomovements in interest rates. Generally, when the fair value ofa derivative contract is positive, the counterparty owes us, thuscreating a performance risk. When the fair value of thederivative contract is negative, we owe the counterparty, andtherefore assume no performance risk.To minimize the risk of credit losses, all derivativetransactions are governed by master swap agreements, whichinclude netting agreements requiring the net settlement ofcovered contracts with the same counterparty in the event ofdefault by the other party. The “net” mark-to-market exposurerepresents the netting of the positive and negative exposureswith that counterparty. The master swap agreements alsoinclude bilateral collateral arrangements, requiring the Bank orits counterparties to post collateral on a daily basis withthresholds set at zero for all active dealer counterparties.Derivative transactions with our customers are securedthrough our loan agreements. We record derivative exposuresand related cash collateral balances at gross amounts in ourconsolidated balance sheets. As of December 31, 2011, ourcounterparties had posted $792.3 million in cash and$58.9 million in securities as collateral with us. The maximumamount of losses we could be exposed to in the event ofnonperformance by dealer counterparties to our derivativepositions, net of collateral held by us, was $18.6 million,$10.6 million and $46.8 million at December 31, 2011, 2010and 2009, respectively.Hedge TerminationsDuring 2011 and 2009, we terminated approximately$2.6 billion and $115.0 million, respectively, in notional valueof interest rate swaps for asset-liability management purposes.These swaps were accounted for as fair value hedges. Wereceived proceeds of $31.8 million in 2011 and $7.2 million in2009 as a result of the hedge contract terminations, which arereflected under operating activities in the consolidatedstatements of cash flows. The previous fair value adjustmentsto the fixed rate debt that was hedged by these contracts willbe amortized over the remaining life of the debt. There wereno interest rate swap terminations in 2010 for asset-liabilitymanagement purposes.We terminated interest rate swaps with customers andoffsetting dealer counterparties totaling notional value of$190.0 million, $260.0 million and $284.0 million in 2011,2010 and 2009, respectively. Proceeds from the customerterminations were offset by proceeds from the offsettingdealer terminations.CoBank 2011 Annual Report95