Note 15: Derivatives and Hedging Activities

3 Months Ended

Sep. 30, 2018

Notes

Note 15: Derivatives and Hedging Activities

NOTE 15:  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 as qualifying hedging relationships.  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.  Five of the seven acquired loans with interest rate swaps have paid off.  The notional amount of the two remaining Valley swaps was $796,000 at September 30, 2018.  At September 30, 2018, excluding the Valley Bank swaps, the Company had 19 interest rate swaps totaling $84.4 million in notional amount with commercial customers, and 19 interest rate swaps with the same notional amount with third parties related to its program.  In addition, the Company has three participation loans purchased totaling $31.4 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, 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.  During the three months ended September 30, 2018 and 2017, the Company recognized net gains of $5,000 and $8,000, respectively, in noninterest income related to changes in the fair value of these swaps.  During the nine months ended September 30, 2018 and 2017, the Company recognized net gains of $53,000 and net losses of $5,000, 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 terminated in 2015 and one agreement terminated in 2017.  The effective portion of the gain or loss on the derivative was reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affected earnings.  No gains and losses related to changes in the fair value were recognized in current earnings during the three or nine months ended September 30, 2018.  During the three and nine months ended September 30, 2017, the Company recognized $110,000 and $293,000, respectively, in interest expense related to the amortization of the cost of the interest rate caps. 

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	September 30,	December 31,
	of Financial Condition	2018	2017
		(In Thousands)
Derivatives not designated
as hedging instruments
Asset Derivatives
Interest rate products	Prepaid expenses and other assets	$          1,453	$             981
Total derivatives not designated
as hedging instruments		$          1,453	$             981
Liability Derivatives
Interest rate products	Accrued expenses and other liabilities	$          1,448	$          1,030
Total derivatives not designated
as hedging instruments		$          1,448	$          1,030

The following table presents the effect of derivative instruments on the statements of comprehensive income for the three and nine months ended September 30, 2018 and 2017: 

	Amount of Gain (Loss)
	Recognized in AOCI
	Three Months Ended September 30,
Cash Flow Hedges	2018	2017
	(In Thousands)
Interest rate cap, net of income taxes	$                             —	$                           64

	Amount of Gain (Loss)
	Recognized in AOCI
	Nine Months Ended September 30,
Cash Flow Hedges	2018	2017
	(In Thousands)
Interest rate cap, net of income taxes	$                             —	$                         161

Agreements with Derivative Counterparties

The Company has agreements with its derivative counterparties.  If the Company defaults on any of its indebtedness, including 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 September 30, 2018, the termination value of derivatives with our derivative dealer counterparties in a net asset position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $1.5 million.  The Company has minimum collateral posting thresholds with its derivative dealer counterparties.  At September 30, 2018, the Company’s activity with certain of its derivative counterparties met the level at which the minimum collateral posting thresholds take effect (collateral to be received by the Company) and the derivative counterparties had posted collateral to the Company to satisfy the agreements.  As of December 31, 2017, the termination value of derivatives in a net liability position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $336,000.  At December 31, 2017, the Company’s activity with its derivative counterparties met the level at which the minimum collateral posting thresholds take effect and the Company posted $809,000 of collateral to satisfy the agreements.  If the Company had breached any of these provisions at September 30, 2018 or December 31, 2017, it could have been required to settle its obligations under the agreements at the termination value.