10.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 its derivatives either as hedging instruments in a qualifying hedge accounting relationship (cash flow or fair value hedge) or as a free standing derivative such as interest rate lock commitments (IRLC) that do not qualify for hedge accounting.  The Company uses interest rate derivatives to manage its exposure to interest rate movements and add stability to interest income and expense.  The Company also enters into back-to-back loan swaps to assist customers in managing changing interest rates. 

 

Cash Flow Hedges

As part of its cash flow hedging strategy, the Company uses interest rate swap agreements to limit the variability of expected future cash flows (primarily associated with the Company’s variable rate borrowings) by exchanging a notional amount, equal to the principal amount of the borrowings, for fixed-rate interest based on benchmarked interest rates.  As of December 31, 2014, the Company had 11 interest rate swaps designated as cash flow hedges with an aggregate notional amount of $263.0 million.

 

The Company entered into three interest rate swap agreements (the “trust swaps”) to mitigate the variable interest rate risk related to trust preferred capital notes further described in Note 8 “Borrowings.”  The Company receives interest of LIBOR from a  counterparty and pays a weighted average fixed rate of 2.77%  to the same counterparty calculated on a notional amount of $68.0 million.  The terms of the trust swaps range from three to six years.

 

The Company entered into four interest rate swap agreements (the “prime loan swaps”) to mitigate the variable interest rate risks of certain prime commercial loans.  The Company receives a fixed interest rate ranging from 4.71% to 5.20% from the counterparty and pays interest based on the Wall Street Journal prime index, with a spread of up to 0.49%, to the same counterparty calculated on a notional amount of $55.0 million.  One of the four prime loan swaps contains a floor rate of 4.00%.  The terms of the four prime loan swaps is six years with a fixed rate that started September 17, 2013.  

 

The Company entered into four interest rate swap agreements (the “FHLB advance swaps”) to mitigate variable interest rate risk on certain designated variable rate FHLB borrowings.  The Company receives an interest rate based on the three month LIBOR from the counterparty and pays an interest rate ranging from 3.16% to 3.46% to the same counterparty calculated on a notional amount of $140.0 million.  The FHLB advance swaps are deferred starting swaps with terms of six years and five years and effective dates of February 23, 2017 and February 23, 2018, respectively.

 

All swaps were entered into with counterparties that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party.  The Company believes that the credit risk inherent in the contract is not significant.  As of December 31, 2014, the Company had $5.7 million of cash pledged as collateral for the trust swaps and securities with a market value of $4.8 million pledged as collateral for the prime loan swaps and FHLB advance swaps.

 

Amounts receivable or payable are recognized as accrued under the terms of the agreements.  In accordance with ASC 815, Derivatives and Hedging, the Company has designated the trust swaps, prime loan swaps, and FHLB advance swaps as cash flow hedges, with the effective portions of the derivatives’ unrealized gains or losses recorded as a component of other comprehensive income.  The ineffective portions of the unrealized gains or losses, if any, would be recorded in interest income and interest expense in the Company’s Consolidated Statements of Income.  The Company has assessed the effectiveness of each hedging relationship by comparing the changes in cash flows on the designated hedged item.  The Company’s cash flow hedges are deemed to be effective.  At December 31, 2014, the fair value of the Company’s cash flow hedges was an unrealized loss of $7.9 million, the amount the Company would have expected to pay if the contract was terminated.  The liability is recorded as a component of other comprehensive income recorded in the Company’s Consolidated Statements of Comprehensive Income. 

 

Shown below is a summary of the derivatives designated as cash flow hedges at December 31, 2014 and 2013 (dollars in thousands):

 

 

Fair Value Hedge

During the normal course of business, the Company enters into interest rate swaps (the “traditional swap”) to convert certain long-term fixed-rate loans to floating rates to hedge the Company’s exposure to interest rate risk.  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.  The ineffective portions of the unrealized gains or losses, if any, would be recorded in interest income and interest expense in the Company’s Consolidated Statements of Income.  The Company uses statistical regression analysis 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. 

 

On December 30, 2014, the Company entered into a traditional swap whereby the Company pays a fixed interest rate of 3.42% to the counterparty and receives interest of one month LIBOR plus 1.93% from the same counterparty calculated on a notional amount of $38.3 million with a term of 15 years.  The traditional swap is designated as a fair value hedge and had no material impact on the Company’s Consolidated Balance Sheets or Statements of Income during 2014. 

 

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 counterparties in order to minimize interest rate risk.  These back-to-back loan swaps qualify as financial derivatives with fair values reported in “Other assets” and “Other liabilities” in the Company’s Consolidated Balance Sheet. As of December 31, 2014, the Company had securities with a market value of $3.4 million pledged as collateral for the loan swaps.  Shown below is a summary regarding loan swap derivative activities at December 31, 2014 and 2013 (dollars in thousands):

 

 

 

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 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 contracts are 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. 

 

During the first quarter of 2014, and in connection with the acquisition of StellarOne, the Company began recording the rate lock commitments derivatives on its balance sheet at fair value.  Because the amounts associated with the rate lock commitments were determined to be immaterial, the Company did not record the value of the rate locks in any period prior to January 1, 2014.  While the rate lock commitment derivatives are still considered immaterial to the consolidated financial statements, the Company began recording these assets on its Consolidated Balance Sheet within “Other Assets” post-acquisition when integrating the acquired mortgage operations of StellarOne.  The Company’s derivatives related to rate lock commitments had a notional amount of $49.6 million at December 31, 2014 with a fair value of $513,000.  These derivative instruments do not qualify for hedge accounting; as a result, changes in fair value are recognized in current period earnings as a component of “Gain on sale of mortgage loans, net of commissions.”