Huntington National Bank 2004 Annual Report Download - page 126

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HUNTINGTON BANCSHARES INCORPORATED
20. DERIVATIVE FINANCIAL INSTRUMENTS
A variety of derivative financial instruments, principally interest rate swaps, are used in asset and liability management activities to
protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash
flows. These instruments provide flexibility in adjusting the Company’s sensitivity to changes in interest rates without exposure to loss
of principal and higher funding requirements. By using derivatives to manage interest rate risk, the effect is a smaller, more efficient
balance sheet, with a lower wholesale funding requirement and a higher net interest margin, but with a comparable level of net
interest revenue and return on equity. All derivatives are reflected at fair value in the consolidated balance sheet. Huntington also uses
derivatives, principally loan sale commitments, in the hedging of its mortgage loan commitments and its mortgage loans held for sale.
Market risk, which is the possibility that economic value of net assets or net interest income will be adversely affected by changes in
interest rates or other economic factors, is managed through the use of derivatives. Derivatives are also sold to meet customers’
financing needs and, like other financial instruments, contain an element of credit risk, which is the possibility that Huntington will
incur a loss because a counter-party fails to meet its contractual obligations. Notional values of interest rate swaps and other off-
balance sheet financial instruments significantly exceed the credit risk associated with these instruments and represent contractual
balances on which calculations of amounts to be exchanged are based. Credit exposure is limited to the sum of the aggregate fair value
of positions that have become favorable to Huntington, including any accrued interest receivable due from counterparties. Potential
credit losses are minimized through careful evaluation of counterparty credit standing, selection of counterparties from a limited
group of high quality institutions, collateral agreements, and other contract provisions.
A SSET AND L IABILITY M ANAGEMENT
Derivatives that are used in asset and liability management are classified as fair value hedges or cash flow hedges and are required to
meet specific criteria. To qualify as a hedge, the hedge relationship is designated and formally documented at inception, detailing the
particular risk management objective and strategy for the hedge. This includes identifying the item and risk being hedged, the
derivative being used, and how the effectiveness of the hedge is being assessed. A derivative must be highly effective in accomplishing
the objective of offsetting either changes in fair value or cash flows for the risk being hedged. Correlation is evaluated on a
retrospective and prospective basis using quantitative measures. If a hedge relationship is found to be ineffective, the derivative no
longer qualifies as a hedge and any excess gains or losses attributable to ineffectiveness, as well as subsequent changes in its fair value,
are recognized in other income.
For fair value hedges, deposits, short-term borrowings, and long-term debt are effectively converted to variable-rate obligations by
entering into interest rate swap contracts whereby fixed-rate interest is received in exchange for variable-rate interest without the
exchange of the contract’s underlying notional amount. Forward contracts, used primarily in connection with its mortgage banking
activities, settle in cash at a specified future date based on the differential between agreed interest rates applied to a notional amount.
The changes in fair value of the hedged item and the hedging instrument are reflected in current earnings. The amounts recognized in
connection with the ineffective portion of Huntington’s fair value hedging in 2004, 2003, and 2002 were insignificant.
For cash flow hedges, interest rate swap contracts were entered into that pay fixed-rate interest in exchange for the receipt of variable-
rate interest without the exchange of the contract’s underlying notional amount, which effectively converts a portion of its floating-
rate debt to fixed-rate. This reduces the potentially adverse impact of increases in interest rates on future interest expense. In like
fashion, certain LIBOR-based commercial and industrial loans were effectively converted to fixed-rate by entering into contracts that
swap variable-rate interest for fixed-rate interest over the life of the contracts.
To the extent these derivatives are effective in offsetting the variability of the hedged cash flows, changes in the derivatives’ fair value
will not be included in current earnings but are reported as a component of accumulated other comprehensive income in
shareholders’ equity. These changes in fair value will be included in earnings of future periods when earnings are also affected by the
changes in the hedged cash flows. To the extent these derivatives are not effective, changes in their fair values are immediately included
in earnings. During 2004, 2003, and 2002, a net loss was recognized in connection with the ineffective portion of its cash flow hedging
instruments. The amounts were classified in other non-interest income and were considered insignificant. No amounts were excluded
from the assessment of effectiveness during 2004 and 2003 for derivatives designated as cash flow hedges.
124