Quarterly report pursuant to Section 13 or 15(d)

DERIVATIVES

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DERIVATIVES
6 Months Ended
Jun. 30, 2016
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
DERIVATIVES
DERIVATIVES
The Company is exposed to economic risks arising from its business operations and uses derivatives primarily to manage risk associated with changing interest rates, and to assist customers with their risk management objectives. The Company designates certain derivatives as hedging instruments in a qualifying hedge accounting relationship (cash flow or fair value hedge). The remaining are classified as free standing derivatives consisting of customer accommodation loan swaps and interest rate lock commitments that do not qualify for hedge accounting.
Cash Flow Hedges
The Company designates derivatives as cash flow hedges when they are used to manage exposure to variability in cash flows related to forecasted transactions on variable rate borrowings such as trust preferred capital notes, FHLB borrowings, and prime commercial loans. The Company uses interest rate swap agreements as part of its hedging strategy by exchanging a notional amount, equal to the principal amount of the borrowings, for fixed-rate interest based on benchmarked interest rates.
All swaps were entered into with counterparties that met the Company’s credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in the contract is not significant.
The terms and conditions of the interest rate swaps vary and amounts receivable or payable are recognized as accrued under the terms of the agreements. The Company assesses the effectiveness of each hedging relationship on a periodic basis using statistical regression analysis. The Company also measures the ineffectiveness of each hedging relationship using the change in variable cash flows method which compares the cumulative changes in cash flows of the hedging instrument relative to cumulative changes in the hedged item’s cash flows. In accordance with ASC 815, Derivatives and Hedging, the effective portions of the derivatives’ unrealized gains or losses are recorded as a component of other comprehensive income. Based on the Company’s assessment its cash flow hedges are highly effective, but to the extent that any ineffectiveness exists in the hedge relationships, the amounts would be recorded in interest income and interest expense in the Company’s Consolidated Statements of Income.
On June 13, 2016, the Company terminated three interest rate swaps designated as cash flow hedges prior to their maturity. The unrealized gain of $1.3 million within accumulated Other Comprehensive Income will be re-classified into earnings over a three year period using the effective interest method. The estimated net amount of gains expected to be reclassified into earnings within the next twelve months is $373,000.
Fair Value Hedge
Derivatives are designated as fair value hedges when they are used to manage exposure to changes in the fair value of certain financial assets and liabilities, referred to as the hedged items, which fluctuate in value as a result of movements in interest rates. During the normal course of business, the Company enters into interest rate swaps to convert certain long-term fixed-rate loans to floating rates to hedge the Company’s exposure to interest rate risk. The Company pays a fixed interest rate to the counterparty and receives a floating rate from the same counterparty calculated on the aggregate notional amount. At June 30, 2016 and December 31, 2015, the aggregate notional amount of the related hedged items was $43.8 million and $61.2 million, respectively, with fair value amounts of $3.6 million and $689,000, respectively.
The Company applies hedge accounting in accordance with ASC 815 and the fair value hedge and the underlying hedged item, attributable to the risk being hedged, are recorded at fair value with unrealized gains and losses being recorded in the Company’s Consolidated Statements of Income. Statistical regression analysis is used to assess hedge effectiveness, both at inception of the hedging relationship and on an ongoing basis. The regression analysis involves regressing the periodic change in fair value of the hedging instrument against the periodic changes in fair value of the asset being hedged due to changes in the hedged risk. The Company’s fair value hedges continue to be highly effective and had no material impact on the Consolidated Statements of Income, but if any ineffectiveness exists, portions of the unrealized gains or losses would be recorded in interest income and interest expense in the Company’s Consolidated Statements of Income.
Loan Swaps
During the normal course of business, the Company enters into interest rate swap loan relationships (“loan swaps”) with borrowers to meet their financing needs. Upon entering into the loan swaps, the Company enters into offsetting positions with a third party in order to minimize interest rate risk. These back-to-back loan swaps qualify as financial derivatives with fair values as reported in “Other Assets” and “Other Liabilities” in the Company’s Consolidated Balance Sheets.
Interest Rate Lock Commitments
During the normal course of business, the Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (“rate lock commitments”).  Rate lock commitments on mortgage loans that are intended to be sold in the secondary market are considered to be derivatives.  The period of time between issuance of a loan commitment, closing, and sale of the loan generally ranges from 30 to 120 days.  The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan.  The correlation between the rate lock commitments and the best efforts contracts is high due to their similarity.
 
The market values of rate lock commitments and best efforts forward delivery commitments is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets.  The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close.  The fair value of the rate lock commitments is reported as a component of “Other Assets” in the Company’s Consolidated Balance Sheets; the fair value of the Company’s best efforts forward delivery commitments is recorded as a component of “Other Liabilities” in the Company’s Consolidated Balance Sheets. Any impact to income is recorded in current period earnings as a component of “Mortgage banking income, net” in the Company’s Consolidated Statements of Income.
 
The following table summarizes key elements of the Company’s derivative instruments as of June 30, 2016 and December 31, 2015, segregated by derivatives that are considered accounting hedges and those that are not (dollars in thousands):
 
 
June 30, 2016
 
December 31, 2015
 
 

Derivative (2)
 
 
 
Derivative (2)
 
 
Notional or
Contractual
Amount (1)
 
Assets
 
Liabilities
 
Collateral
Pledged (3)
 
Notional or
Contractual
Amount (1)
 
Assets
 
Liabilities
 
Collateral
Pledged (3)
Derivatives designated as accounting hedges:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest rate contracts:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Cash flow hedges
$
220,500

 
$
382

 
$
17,263

 
$
21,774

 
$
263,000

 
$
946

 
$
10,352

 
$
14,449

Fair value hedges
43,845

 

 
3,816

 

 
61,150

 

 
888

 

Derivatives not designated as accounting hedges:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Loan Swaps (4)
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Pay fixed - receive floating interest rate swaps
218,614

 
11,948

 

 

 
138,969

 
3,758

 

 

Pay floating - receive fixed interest rate swaps
218,614

 

 
11,948

 
15,885

 
138,969

 

 
3,758

 
5,983

Other contracts:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest rate lock commitments
71,861

 
1,712

 

 

 
50,369

 
701

 

 

 
(1) Notional amounts are not recorded on the balance sheet and are generally used only as a basis on which interest and other payments are determined.
(2) Balances represent fair value of derivative financial instruments.
(3) Collateral pledged is comprised of both cash and securities.
(4) Prior period reflects reclassifications to conform to the current presentation.