NOTE 11: Derivative Financial Instruments

The Corporation uses derivative financial instruments primarily to manage risks to the Corporation associated with changing interest rates, and to assist customers with their risk management objectives. The Corporation designates certain interest rate swaps as hedging instruments in qualifying cash flow hedges. The changes in fair value of these designated hedging instruments is reported as a component of other comprehensive income. Derivative contracts that are not designated in a qualifying hedging relationship include customer accommodation loan swaps and contracts related to mortgage banking activities.

Cash flow hedges. The Corporation designates interest rate swaps as cash flow hedges when they are used to manage exposure to variability in cash flows on variable rate borrowings such as the Corporation’s trust preferred capital notes. These interest rate swaps are derivative financial instruments that manage the risk of variability in cash flows by exchanging variable-rate interest payments on a notional amount of the Corporation’s borrowings for fixed-rate interest payments. Interest rate swaps designated as cash flow hedges are expected to be highly effective in offsetting the effect of changes in interest rates on the amount of variable-rate interest payments, and the Corporation assesses the effectiveness of each hedging relationship quarterly. If the Corporation determines that a cash flow hedge is no longer highly effective, future changes in the fair value of the hedging instrument would be reported in earnings. As of September 30, 2019, the Corporation has designated cash flow hedges to manage its exposure to variability in cash flows on certain variable rate borrowings for periods that end between June 2024 and June 2029.

All interest rate swaps were entered into with counterparties that met the Corporation’s credit standards and the agreements contain collateral provisions protecting the at-risk party. The Corporation believes that the credit risk inherent in these derivative contracts is not significant.

Unrealized gains or losses recorded in other comprehensive income related to cash flow hedges are reclassified into earnings in the same period(s) during which the hedged interest payments affect earnings. When a designated hedging instrument is terminated and the hedged interest payments remain probable of occurring, any remaining unrecognized gain or loss in other comprehensive income is reclassified into earnings in the period(s) during which the forecasted interest payments affect earnings. Amounts reclassified into earnings and interest receivable or payable under designated interest rate swaps are reported in interest expense. The Corporation does not expect any unrealized losses related to cash flow hedges to be reclassified into earnings in the next twelve months.

Loan swaps. The Bank also enters into interest rate swaps with certain qualifying commercial loan customers to meet their interest rate risk management needs. The Bank simultaneously enters into interest rate swaps with dealer counterparties, with identical notional amounts and offsetting terms. The net result of these interest rate swaps is that the customer pays a fixed rate of interest and the Corporation receives a floating rate. These back-to-back loan swaps are derivative financial instruments and are reported at fair value in other assets and other liabilities in the Consolidated Balance Sheets. Changes in the fair value of loan swaps are recorded in other noninterest expense and sum to zero because of the offsetting terms of swaps with borrowers and swaps with dealer counterparties.

Mortgage banking. C&F Mortgage enters into IRLCs with customers to originate loans for which the interest rates are determined (or “locked”) prior to funding. C&F Mortgage is exposed to interest rate risk by holding fixed-rate IRLCs and mortgage loans from the time that interest rates are locked until the loans are sold in the secondary market. C&F Mortgage mitigates this interest rate risk by either (1) entering into forward sales contracts with investors at the time that interest rates are locked for mortgage loans to be delivered on a best efforts basis or (2) entering into forward sales contracts for unspecified mortgage backed securities (TBA securities) until it can enter into forward sales contracts with investors for mortgage loans to be delivered on a mandatory basis. IRLCs, forward sales of loans and forward sales of TBA securities are derivative financial instruments and are reported at fair value in other assets and other liabilities in the Consolidated Balance Sheets. Changes in the fair value of mortgage banking derivatives are recorded as a component of gains on sales of loans.

At September 30, 2019, C&F Mortgage had best-efforts forward sales contracts for $84.22 million of its mortgage loans held for sale and $95.99 million of IRLCs offered to customers, and it had mandatory-delivery forward sales contracts for $5.44 million of its mortgage loans held for sale. At December 31, 2018, C&F Mortgage had best-efforts forward sales contracts for all of its mortgage loans held for sale and IRLCs.

The following tables summarize key elements of the Corporation’s derivative instruments other than forward sales of mortgage loans. The fair values of forward sales of mortgage loans were not material to the consolidated financial statements of the Corporation at September 30, 2019 or December 31, 2018.


	September 30, 2019
	Notional						Collateral
(Dollars in thousands)	Amount		Assets		Liabilities		Pledged1
Cash flow hedges:
Interest rate swap contracts	$	25,000	$	—	$	592	$	—
Not designated as hedges:
Customer-related interest rate swap contracts:
Matched interest rate swaps with borrower		66,305		3,484		—		—
Matched interest rate swaps with counterparty		66,305		—		3,484		—
Mortgage banking contracts:
IRLCs		116,927		1,760		—		—
Forward sales of TBA securities		23,250		—		56		—


	December 31, 2018
	Notional						Collateral
(Dollars in thousands)	Amount		Assets		Liabilities		Pledged1
Cash flow hedges:
Interest rate swap contracts	$	25,000	$	289	$	—	$	—
Not designated as hedges:
Customer-related interest rate swap contracts:
Matched interest rate swaps with borrower		45,961		216		1,391		—
Matched interest rate swaps with counterparty		45,961		1,391		216		—
Mortgage banking contracts:
IRLCs		44,324		636		—		—

Collateral pledged may be comprised of cash or securities.