8.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 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 the risks due to 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 September 30, 2015, the Company had 11 interest rate swaps designated as cash flow hedges with an aggregate notional amount of $263.0 million.

 

The Company has entered into three interest rate swap agreements (the “trust swaps”) to mitigate the variable interest rate risk related to the trust preferred capital notes further described in Note 6 “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 original terms of the trust swaps range from three to six years. 

 

The Company has 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 original terms of the four prime loan swaps is six years with a fixed rate that started September 17, 2013.  

 

The Company has entered into four interest rate swap agreements (“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 agreements contain collateral provisions protecting the at-risk party.  The Company believes that the credit risk inherent in the contract is not significant.  As of September 30, 2015, the Company had $10.0 million of cash pledged as collateral for the cash flow hedges and securities with a market value of $4.3 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 of the hedging instrument.  Based on the Company’s assessment, its cash flow hedges are highly effective.  At September 30, 2015, the fair value of the Company’s cash flow hedges was a net unrealized loss of $10.4 million, the amount the Company would have expected to pay if the contracts were terminated.

 

Shown below is a summary of the derivatives designated as cash flow hedges at September 30, 2015 and December 31, 2014 (dollars in thousands):

 

 

 

 

Fair Value Hedge

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 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.

 

As of September 30, 2015, the Company had three swaps constituting fair value hedges, whereby the Company pays a fixed interest rate ranging from 3.23% to 3.53% to the counterparty and receives interest of one month LIBOR plus a spread of up to 2.13% from the same counterparty calculated on an aggregate notional amount of $53.6 million with terms ranging from 15 to 17 years.  At December 31, 2014, the Company had one fair value hedge with an aggregate notional amount of $38.3 million.  At September 30, 2015, the fair value of the Company’s fair value hedges was an unrealized loss of $1.4 million, the amount the Company would have expected to pay if the contract was terminated; the liability is reported in “Other Liabilities” in the Company’s Consolidated Balance Sheets.  At September 30, 2015, the aggregate notional amount of the hedged items was $53.6 million with a fair value of $1.4 million.  At December 31, 2014, the Company had one hedged item with an aggregate notional amount  of $38.3 million.  The Company’s fair value hedges continue to be highly effective and had no material impact on 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 counterparties 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.  As of September 30, 2015, the Company had cash and securities with a market value of $6.6 million pledged as collateral for the loan swaps. 

 

Shown below is a summary regarding loan swap derivative activities at September 30, 2015 and December 31, 2014 (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 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 as of September 30, 2015 was $1.3 million and 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 was $544,000 and 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 “Gain on sale of mortgage loans, net of commissions” in the Company’s Consolidated Statements of Income.  The aggregate notional amount of these derivatives was $61.0 million and $49.6 million at September 30, 2015 and December 31, 2014, respectively.