DERIVATIVES

9 Months Ended

Sep. 30, 2021

DERIVATIVES

DERIVATIVES

10. DERIVATIVES

The Company’s derivative financial instruments are used to manage differences in the amount, timing and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives to accommodate the business requirements of its customers. All derivatives are recognized as either assets or liabilities on the balance sheet and are measured at fair value. The accounting for changes in the fair value of a derivative instrument depends upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.

Interest Rate Swaps Designated as a Cashflow Hedge

As part of its interest rate risk management strategy, the Company utilizes interest rate swap agreements to help manage its interest rate risk positions. The notional amount of the interest rate swaps do not represent the amount exchanged by the parties. The exchange of cash flows is determined by reference to the notional amounts and the other terms of the interest rate swap agreements. The changes in fair value of derivatives designated as cash flow hedges are recorded in other comprehensive income and subsequently reclassified to earnings when gains or losses are realized.

As of September 30, 2021, the Company had one interest rate swap agreement with a notional amount of $100.0 million that was designated as a cash flow hedge of certificates of deposits. The interest rate swap agreement has an average maturity of 3.52 years, the current weighted average fixed rate paid is 0.67%, the weighted average 3-month LIBOR swap receive rate is 0.12%, and the fair value is $358,000. The Company expects approximately $506,000 related to the cash flow hedge to be reclassified to interest expense, from other comprehensive income, in the next twelve months.

Derivative Loan Commitments

Mortgage loan commitments qualify as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding. The Company enters into commitments to fund residential mortgage loans at specified times in the future, with the intention that these loans will subsequently be sold in the secondary market. A mortgage loan commitment binds the Company to lend funds to a potential borrower at a specified interest rate and within a specified period of time, generally up to 60 days after inception of the rate lock.

Outstanding derivative loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might decline from inception of a rate lock to funding of the loan due to increases in mortgage interest rates. If interest rates increase, the value of these loan commitments decreases. Conversely, if interest rates decrease, the value of these loan commitments increases.  

Forward Loan Sale Commitments

The Company utilizes both “mandatory delivery” and “best efforts” forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments.  

With a “mandatory delivery” contract, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the number of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a “pair-off” fee, based on then-current market prices, to the investor to compensate the investor for the shortfall.

With a “best efforts” contract, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, the price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower).

The Company expects that these forward loan sale commitments will experience changes in fair value opposite to the change in fair value of derivative loan commitments.  

Interest Rate Swaps

The Company enters into interest rate swap agreements that are transacted to meet the financing needs of its commercial customers. Offsetting interest rate swap agreements are simultaneously transacted with a third-party financial institution to effectively eliminate the Company’s interest rate risk associated with the customer swaps. The primary risks associated with these transactions arise from exposure to the ability of the counterparties to meet the terms of the contract. Mortgage-backed securities with a fair value of $20.5 million are pledged to secure the Company’s liability for the offsetting interest rate swaps (see Note 2). The interest rate swap notional amount is the aggregate notional amount of the customer swap and the offsetting third-party swap.

Risk Participation Agreements

The Company has entered into risk participation agreements with the correspondent institutions and shares in any interest rate swap losses incurred as a result of the commercial loan customers’ termination of a loan-level interest rate swap agreement prior to maturity. The Company records these risk participation agreements at fair value. The Company’s maximum credit exposure is based on its proportionate share of the settlement amount of the referenced interest rate swap. Settlement amounts are generally calculated based on the fair value of the swap plus outstanding accrued interest receivables from the customer.

Although the Company has determined that the majority of the inputs used to value its interest rate swaps and risk participation agreements fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with interest rate contracts and risk participation agreements utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties. However, as of September 30, 2021 and December 31, 2020, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has classified its derivative valuations in their entirety as Level 2.

The following tables presents the outstanding notional balances and fair values of outstanding derivative instruments:

			Assets			Liabilities
			Balance			Balance
	Notional		Sheet	Fair		Sheet	Fair
	Amount		Location	Value		Location	Value
		(in thousands)
September 30, 2021:
Derivatives designated as Hedging Instruments
Interest rate swaps	$	100,000	Other assets	$	358	Other liabilities	$	—
Derivatives not designated as Hedging Instruments
Derivative loan commitments	$	261,202	Other assets	$	3,147	Other liabilities	$	43
Forward loan sale commitments		173,725	Other assets		884	Other liabilities		29
Interest rate swaps		764,430	Other assets		22,506	Other liabilities		22,506
Risk participation agreements		139,506	Other assets		—	Other liabilities		—
Total				$	26,895		$	22,578
December 31, 2020:
Derivatives designated as Hedging Instruments
Interest rate swaps	$	100,000	—	$	—	Other liabilities	$	1,407
Derivatives not designated as Hedging Instruments
Derivative loan commitments	$	485,428	Other assets	$	12,623	Other liabilities	$	341
Forward loan sale commitments		356,500	Other assets		—	Other liabilities		2,204
Interest rate swaps		867,728	Other assets		39,320	Other liabilities		39,320
Risk participation agreements		132,379	Other assets		—	Other liabilities		—
Total				$	51,943		$	43,272

The following table presents the recorded net gains and losses pertaining to the Company’s derivative instruments:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
	(in thousands)
Derivatives designated as hedging instruments
Gain (loss) in OCI on derivatives (effective portion), net of tax	$	116	$	82	$	1,271	$	(1,187)
Loss reclassified from OCI into interest income or interest expense (effective portion)	$	(140)	$	(82)	$	(373)	$	67
Derivatives not designated as hedging instruments
Changes in fair value of derivative loan commitments
Mortgage banking income	$	(1,897)	$	4,738	$	(9,178)	$	14,266
Changes in fair value of forward loan sale commitments
Mortgage banking income		1,064		755		3,059		(1,075)
Total	$	(833)	$	5,493	$	(6,119)	$	13,191