Note 17: Derivatives and Hedging Activities

12 Months Ended

Dec. 31, 2017

Notes

Note 17: Derivatives and Hedging Activities

Note 17:    Derivatives and Hedging Activities

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions.  The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities.  The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources and duration of its assets and liabilities.  In the normal course of business, the Company may use derivative financial instruments (primarily interest rate swaps) from time to time to assist in its interest rate risk management.  The Company has interest rate derivatives that result from a service provided to certain qualifying loan customers that are not used to manage interest rate risk in the Company’s assets or liabilities and are not designated in a qualifying hedging relationship.  The Company manages a matched book with respect to its derivative instruments in order to minimize its net risk exposure resulting from such transactions.  In addition, the Company has interest rate derivatives that are designated in a qualified hedging relationship. 

Nondesignated Hedges

The Company has interest rate swaps that are not designated in a qualifying hedging relationship.  Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain loan customers, which the Company began offering during 2011.  The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies.  Those interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions.  As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings. 

As part of the Valley Bank FDIC-assisted acquisition, the Company acquired seven loans with related interest rate swaps.  Valley’s swap program differed from the Company’s in that Valley did not have back to back swaps with the customer and a counterparty.  Two of the seven acquired loans with interest rate swaps have paid off.  The notional amount of the five remaining Valley swaps is $3.6 million at December 31, 2017.  As of December 31, 2017, excluding the Valley Bank swaps, the Company had 22 interest rate swaps totaling $92.7 million in notional amount with commercial customers, and 22 interest rate swaps with the same notional amount with third parties related to its program.  In addition, the Company has two participation loans purchased totaling $22.0 million, in which the lead institution has an interest rate swap with their customer and the economics of the counterparty swap are passed along to us through the loan participation.  As of December 31, 2016, excluding the Valley Bank swaps, the Company had 26 interest rate swaps totaling $110.7 million in notional amount with commercial customers, and 26 interest rate swaps with the same notional amount with third parties related to its program.  During the years ended December 31, 2017, 2016 and 2015, the Company recognized net gains and (losses) of $28,000, $66,000 and $(43,000), respectively, in noninterest income related to changes in the fair value of these swaps. 

Cash Flow Hedges

As a strategy to maintain acceptable levels of exposure to the risk of changes in future cash flows due to interest rate fluctuations, the Company entered into two interest rate cap agreements for a portion of its floating rate debt associated with its trust preferred securities.  One agreement, with a notional amount of $25 million, stated that the Company would pay interest on its trust preferred debt in accordance with the original debt terms at a rate of 3-month LIBOR + 1.60%.  Should interest rates rise above a certain threshold, the counterparty would reimburse the Company for interest paid such that the Company would have an effective interest rate on that portion of its trust preferred securities no higher than 2.37%.  The agreement became effective on August 1, 2013 and had a term of four years, which terminated during 2017.  The other agreement, with a notional amount of $5 million, was terminated when the Company purchased the related trust preferred securities in July 2015.  See Item 8, Financial Statements and Supplementary Information, in the Company’s December 31, 2015 Annual Report on Form 10-K for more information on the trust preferred securities purchase transaction. 

The effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.  Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.  During the years ended December 31, 2017, 2016 and 2015, the Company recognized $-0- in noninterest income related to changes in the fair value of these derivatives.  During the years ended December 31, 2017, 2016 and 2015, the Company recognized $293,000, $225,000 and $187,000, respectively, in interest expense related to the amortization of the cost of these interest rate caps.  During the year ended December 31, 2015, one of the agreements was terminated early as noted above.  As part of this termination, the remaining cost of the cash flow hedge, $95,000, was recognized as interest expense in 2015 (included in the $187,000 discussed here).

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Consolidated Statements of Financial Condition:

	Location in	Fair Value
	Consolidated Statements	December 31,	December 31,
	of Financial Condition	2017	2016
		(In Thousands)
Derivatives designated as
hedging instruments
Interest rate caps	Prepaid expenses and other assets	$                     --	$                   40
Total derivatives designated
as hedging instruments		$                     --	$                   40
Derivatives not designated
as hedging instruments
Asset Derivatives
Derivatives not designated
as hedging instruments
Interest rate products	Prepaid expenses and other assets	$                981	$             1,623
Total derivatives not
designated as hedging
instruments		$                981	$             1,623
Liability Derivatives
Derivatives not designated
as hedging instruments
Interest rate products	Accrued expenses and other liabilities	$             1,030	$             1,699
Total derivatives not
designated as hedging
instruments		$             1,030	$             1,699

The following tables present the effect of derivative instruments on the statements of comprehensive income: 

	Year Ended December 31
Cash Flow Hedges	Amount of Gain (Loss) Recognized in AOCI
	2017	2016	2015
	(In Thousands)
Interest rate cap, net of income taxes	$               161	$                 87	$                (50)

Agreements with Derivative Counterparties

The Company has agreements with its derivative counterparties.  If the Company defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.  If the Bank fails to maintain its status as a well-capitalized institution, then the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.  Similarly, the Company could be required to settle its obligations under certain of its agreements if certain regulatory events occurred, such as the issuance of a formal directive, or if the Company’s credit rating is downgraded below a specified level.

As of December 31, 2017, the termination value of derivatives with our derivative dealer counterparties in a net liability position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $336,000.  The Company has minimum collateral posting thresholds with its derivative dealer counterparties.  At December 31, 2017, the Company’s activity with its derivative dealer counterparties had met the level at which the minimum collateral posting thresholds take effect and the Company had posted $809,000 of collateral to satisfy the agreement.  As of December 31, 2016, the termination value of derivatives with our derivative dealer counterparties in a net liability position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $1.6 million.  At December 31, 2016, the Company’s activity with its derivative dealer counterparties met the level in which the minimum collateral posting thresholds take effect and the Company had posted $6.0 million of collateral to satisfy the agreement.  If the Company had breached any of these provisions at December 31, 2017 and 2016, it could have been required to settle its obligations under the agreements at the termination value.