Note 16: Derivatives and Hedging Activities

12 Months Ended

Dec. 31, 2019

Notes

Note 16: Derivatives and Hedging Activities

Note 16:     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.  Five of the seven acquired loans with interest rate swaps have paid off.  The notional amount of the two remaining Valley swaps was $689,000 at December 31, 2019.  At December 31, 2019, excluding the Valley Bank swaps, the Company had 19 interest rate swaps totaling $96.0 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 at December 31, 2019, the Company had five participation loans purchased totaling $37.4 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.  At December 31, 2018, excluding the Valley Bank swaps, the Company had 18 interest rate swaps totaling $78.5 million in notional amount with commercial customers, and 18 interest rate swaps with the same notional amount with third parties related to its program.  In addition at December 31, 2018, the Company had three participation loans purchased totaling $31.2 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. During the years ended December 31, 2019, 2018 and 2017, the Company recognized net gains (losses) of $(104,000), $25,000 and $28,000, respectively, in noninterest income related to changes in the fair value of these swaps. 

Cash Flow Hedges

Interest Rate Swap.  As a strategy to maintain acceptable levels of exposure to the risk of changes in future cash flows due to interest rate fluctuations, in October 2018, the Company entered into an interest rate swap transaction as part of its ongoing interest rate management strategies to hedge the risk of its floating rate loans.  The notional amount of the swap is $400 million with a termination date of October 6, 2025.  Under the terms of the swap, the Company will receive a fixed rate of interest of 3.018% and will pay a floating rate of interest equal to one-month USD-LIBOR.  The floating rate will be reset monthly and net settlements of interest due to/from the counterparty will also occur monthly.  The floating rate of interest was 1.71% as of December 31, 2019.  Therefore, in the near term, the Company will receive net interest settlements which will be recorded as loan interest income, to the extent that the fixed rate of interest continues to exceed one-month USD-LIBOR.  If USD-LIBOR exceeds the fixed rate of interest in future periods, the Company will be required to pay net settlements to the counterparty and will record those net payments as a reduction of interest income on loans.  The Company recorded interest income of $3.1 million and $673,000 on this interest rate swap during the year ended December 31, 2019 and 2018, respectively.  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 affected 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 each of the years ended December 31, 2019 and 2018, the Company recognized $-0- in noninterest income related to changes in the fair value of this derivative.  

Interest Rate Cap.  Previously, 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 is 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.  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 year ended December 31, 2017, the Company recognized $-0- in noninterest income related to changes in the fair value of these derivatives.  During the year ended December 31, 2017, the Company recognized $244,000 in interest expense related to the amortization of the cost of these 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		December 31,		December 31,
	of Financial Condition		2019		2018
			(In Thousands)
Derivatives designated as
hedging instruments
Interest rate swap	Prepaid expenses and other assets	$	30,056	$	12,106
Total derivatives designated
as hedging instruments		$	30,056	$	12,106
Derivatives not designated
as hedging instruments
Derivative Assets
Derivatives not designated
as hedging instruments
Interest rate products	Prepaid expenses and other assets	$	1,420	$	694
Total derivatives not
designated as hedging
instruments		$	1,420	$	694
Derivative Liabilities
Derivatives not designated
as hedging instruments
Interest rate products	Accrued expenses and other liabilities	$	1,547	$	716
Total derivatives not
designated as hedging
instruments		$	1,547	$	716

The following table presents the effect of cash flow hedge accounting on the statements of comprehensive income: 

		Year Ended December 31
		Amount of Gain (Loss) Recognized in AOCI
Cash Flow Hedges		2019		2018		2017
		(In Thousands)
Interest rate swap (2019 and 2018) and interest rate cap (2017),      net of income taxes	$	13,857	$	9,345	$	161

The following table presents the effect of cash flow hedge accounting on the statements of operations: 

		Year Ended December 31
Cash Flow Hedges		2019				2018				2017
		Interest		Interest		Interest		Interest		Interest		Interest
		Income		Expense		Income		Expense		Income		Expense
		(In Thousands)
Interest rate swap (2019 and 2018) and interest rate cap (2017), net of income taxes	$	3,082	$	—	$	673	$	—	$	—	$	244

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.

At December 31, 2019, the termination value of derivatives with our derivative dealer counterparties (related to loan level swaps with commercial lending customers) in a net liability position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $1.1 million.  In addition, as of December 31, 2019, the termination value of derivatives with our derivative dealer counterparty (related to the balance sheet hedge commenced in October 2018) in a net asset position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $30.1 million.  The Company has minimum collateral posting thresholds with its derivative dealer counterparties.  At December 31, 2019, the Company’s activity with one 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 of $30.9 million to the Company to satisfy the balance sheet hedge agreement.  Additionally, the Company’s activity with one of its derivative counterparties met the level at which the minimum collateral posting thresholds take effect (collateral to be given by the Company) and the Company had posted collateral of $1.1 million to the derivative counterparties to satisfy the loan level agreements.  If the Company had breached any of these provisions at December 31, 2019 or December 31, 2018, it could have been required to settle its obligations under the agreements at the termination value.  At December 31, 2018, the termination value of derivatives with our derivative dealer counterparties (related to loan level swaps with commercial lending customers) in a net asset position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $396,000.  In addition, as of December 31, 2018, the termination value of derivatives with our derivative dealer counterparty (related to the balance sheet hedge commenced in October 2018) in a net asset position, which included accrued interest but excluded any adjustment for nonperformance risk, related to these agreements was $12.3 million.  At December 31, 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 of $704,000 to the Company to satisfy the loan level agreements and collateral of $12.8 million to the Company to satisfy the balance sheet hedge agreement.