DERIVATIVE FINANCIAL INSTRUMENTS

Heartland uses derivative financial instruments as part of its interest rate risk management strategy. As part of the strategy, Heartland considers the use of interest rate swaps, caps, floors, collars, and certain interest rate lock commitments and forward sales of securities related to mortgage banking activities. Heartland's current strategy includes the use of interest rate swaps, interest rate lock commitments and forward sales of mortgage securities. In addition, Heartland is facilitating back-to-back loan swaps to assist customers in managing interest rate risk. Heartland's objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amounts to be exchanged between the counterparties. Heartland is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. Heartland minimizes this risk by entering into derivative contracts with counterparties that meet Heartland’s credit standards, and the contracts contain collateral provisions protecting the at-risk party. Heartland has not experienced any losses from nonperformance by these counterparties. Heartland monitors counterparty risk in accordance with the provisions of ASC 815.

In addition, interest rate-related derivative instruments generally contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. Heartland was required to pledge $2.2 million of cash as collateral at both September 30, 2017, and December 31, 2016. No collateral was required to be pledged by Heartland's counterparties at both September 30, 2017, and December 31, 2016.

Heartland's derivative and hedging instruments are recorded at fair value on the consolidated balance sheets. See Note 8, “Fair Value,” for additional fair value information and disclosures.

Cash Flow Hedges

Heartland has variable rate funding which creates exposure to variability in interest payments due to changes in interest rates. To manage the interest rate risk related to the variability of interest payments, Heartland has entered into various interest rate swap agreements. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received or made on Heartland's variable-rate liabilities. For the nine months ended September 30, 2017, the change in net unrealized losses on cash flow hedges reflects changes in the fair value of the swaps and reclassification from accumulated other comprehensive income to interest expense totaling $1.0 million. For the next twelve months, Heartland estimates that cash payments and reclassification from accumulated other comprehensive income to interest expense will total $1.2 million.

Heartland entered into five forward starting interest rate swap transactions to effectively convert Heartland Financial Statutory Trust IV, V, and VII, which total $65.0 million, as well as Morrill Statutory Trust I and II, which total $20.0 million, from variable rate subordinated debentures to fixed rate debt. For accounting purposes, these five swap transactions are designated as cash flow hedges of the changes in LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on $85.0 million of Heartland's subordinated debentures that reset quarterly on a specified reset date. At inception, Heartland asserted that the underlying principal balance would remain outstanding throughout the hedge transaction, making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.

During the first quarter of 2015, Heartland entered into two additional forward starting interest rate swaps. The first forward starting interest rate swap transaction relates to Heartland's $20.0 million Statutory Trust VI, which converted from a fixed interest rate subordinated debenture to a variable interest rate subordinated debenture effective on June 15, 2017. The forward starting swap transaction expires on June 15, 2024. The second forward starting interest rate swap was effective on March 1, 2017, and replaced the interest rate swap related to Heartland Statutory Trust VII upon its expiration on March 1, 2017.

The table below identifies the balance sheet category and fair values of Heartland's derivative instruments designated as cash flow hedges at September 30, 2017, and December 31, 2016, in thousands:



	Notional Amount		Fair Value			Balance Sheet Category	Receive Rate		Weighted Average Pay Rate		Maturity
September 30, 2017
Interest rate swap	$	25,000	$	(346	)	Other liabilities	1.321	%	2.255	%	03/17/2021
Interest rate swap	—		—			Other liabilities	—	%	3.220	%	03/01/2017
Interest rate swap	20,000		(828		)	Other liabilities	1.303	%	3.355	%	01/07/2020
Interest rate swap	10,000		(6		)	Other liabilities	1.329	%	1.674	%	03/26/2019
Interest rate swap	10,000		(5		)	Other liabilities	1.321	%	1.658	%	03/18/2019
Interest rate swap	35,667		557			Other assets	3.735	%	3.674	%	05/10/2021
Interest rate swap	20,000		(393		)	Other liabilities	1.320	%	2.390	%	06/15/2024
Interest rate swap	20,000		(365		)	Other liabilities	1.316	%	2.352	%	03/01/2024
December 31, 2016
Interest rate swap	$	25,000	$	(447	)	Other liabilities	0.993	%	2.255	%	03/17/2021
Interest rate swap	20,000		(114		)	Other liabilities	0.931	%	3.220	%	03/01/2017
Interest rate swap	20,000		(1,145		)	Other liabilities	0.868	%	3.355	%	01/07/2020
Interest rate swap	10,000		(42		)	Other liabilities	0.997	%	1.674	%	03/26/2019
Interest rate swap	10,000		(41		)	Other liabilities	0.993	%	1.658	%	03/18/2019
Interest rate swap	37,667		530			Other assets	3.164	%	3.674	%	05/10/2021
Interest rate swap⁽¹⁾	20,000		(214		)	Other liabilities	—	%	2.390	%	06/15/2024
Interest rate swap⁽²⁾	20,000		(262		)	Other Liabilities	—	%	2.352	%	03/01/2024

(1) This swap is a forward starting swap with a weighted average pay rate of 2.390% beginning on June 15, 2017. No interest payments were required on this swap until September 15, 2017.
(2) This swap is a forward starting swap with a weighted average pay rate of 2.352% beginning on March 1, 2017. No interest payments were required on this swap until June 1, 2017.

The table below identifies the gains and losses recognized on Heartland's derivative instruments designated as cash flow hedges for the three- and nine-month periods ended September 30, 2017, and September 30, 2016, in thousands:



	Effective Portion							Ineffective Portion
	Recognized in OCI			Reclassified from AOCI into Income				Recognized in Income on Derivatives
	Amount of Gain (Loss)			Category	Amount of Gain (Loss)			Category	Amount of Gain (Loss)
Three Months Ended September 30, 2017
Interest rate swaps	$	325		Interest expense	$	(308	)	Other income	$	—
Nine Months Ended September 30, 2017
Interest rate swaps	$	349		Interest expense	$	(1,005	)	Other income	$	—
Three Months Ended September 30, 2016
Interest rate swaps	$	1,336		Interest expense	$	(492	)	Other income	$	—
Nine Months Ended September 30, 2016
Interest rate swaps	$	(3,160	)	Interest expense	$	(1,463	)	Other income	$	—

Fair Value Hedges

Heartland uses interest rate swaps to convert certain long term fixed rate loans to floating rates to hedge interest rate risk exposure. Heartland uses hedge accounting in accordance with ASC 815, with the unrealized gains and losses, representing the change in fair value of the derivative and the change in fair value of the risk being hedged on the related loan, being recorded in the consolidated statements of income. The ineffective portions of the unrealized gains or losses, if any, are recorded in interest income and interest expense in the consolidated statements of income. Heartland uses statistical regression to assess hedge effectiveness, both at the inception of the hedge as well as on a continual basis. The regression analysis involves regressing the periodic change in the fair value of the hedging instrument against the periodic changes in the fair value of the asset being hedged due to changes in the hedge risk.

Heartland was required to pledge $4.5 million and $5.0 million of cash as collateral for these fair value hedges at September 30, 2017, and December 31, 2016, respectively.

The table below identifies the notional amount, fair value and balance sheet category of Heartland's fair value hedges at September 30, 2017, and December 31, 2016, in thousands:



	Notional Amount		Fair Value			Balance Sheet Category
September 30, 2017
Fair value hedges	$	35,813	$	(1,537	)	Other liabilities
December 31, 2016
Fair value hedges	$	40,807	$	(1,626	)	Other liabilities

The table below identifies the gains and losses recognized on Heartland's fair value hedges for the three- and nine-month periods ended September 30, 2017, and September 30, 2016, in thousands:



	Amount of Gain (Loss)			Income Statement Category
Three Months Ended September 30, 2017
Fair value hedges	$	(63	)	Interest income
Nine Months Ended September 30, 2017
Fair value hedges	$	89		Interest income
Three Months Ended September 30, 2016
Fair value hedges	$	(225	)	Interest income
Nine Months Ended September 30, 2016
Fair value hedges	$	(2,335	)	Interest income

Embedded Derivatives

Heartland has fixed rate loans with embedded derivatives. The loans contain terms that affect the cash flows or value of the loan similar to a derivative instrument, and therefore are considered to contain an embedded derivative. The embedded derivatives are bifurcated from the loans because the terms of the derivative instrument are not clearly and closely related to the loans. The embedded derivatives are recorded at fair value on the consolidated balance sheets as a part of other assets, and changes in the fair value are a component of noninterest income. The table below identifies the notional amount, fair value and balance sheet category of Heartland's embedded derivatives at September 30, 2017, and December 31, 2016, in thousands:



	Notional Amount		Fair Value		Balance Sheet Category
September 30, 2017
Embedded derivatives	$	14,175	$	923	Other assets
December 31, 2016
Embedded derivatives	$	14,549	$	1,104	Other assets

The table below identifies the gains and losses recognized on Heartland's embedded derivatives for the three- and nine-month periods ended September 30, 2017, and September 30, 2016, in thousands:



	Amount of Gain (Loss)			Income Statement Category
Three Months Ended September 30, 2017
Embedded derivatives	$	(296	)	Other noninterest income
Nine Months Ended September 30, 2017
Embedded derivatives	$	(181	)	Other noninterest income
Three Months Ended September 30, 2016
Embedded derivatives	$	(173	)	Other noninterest income
Nine Months Ended September 30, 2016
Embedded derivatives	$	243		Other noninterest income

In conjunction with the CIC Bancshares, Inc. transaction on February 5, 2016, Heartland assumed convertible subordinated debt. The subordinated debt has a face value of $2.0 million, and the embedded conversion option allows the holder to convert the debt to Heartland common equity in any increment and at the discretion of the holder. The conversion option is bifurcated from the debt because the terms of the conversion option are not clearly and closely related to the terms of the debt. On February 5, 2016, the total number of shares to be issued upon conversion was 73,394.

At December 31, 2016, the remaining shares to be issued upon conversion totaled 20,481. During 2017, all of the remaining convertible subordinated debt was converted to common stock, resulting in the issuance of 20,481 shares of common stock. The embedded conversion option was reported at fair value on the consolidated balance sheets using the Black-Scholes model. The following table identifies, in thousands, the notional amount, fair value, balance sheet category and income statement category for the change in fair value of the embedded conversion option as of September 30, 2017, and December 31, 2016:



	Notional Amount		Fair Value			Balance Sheet Category
September 30, 2017
Embedded conversion option	$	—	$	—		Other liabilities
December 31, 2016
Embedded conversion option	$	558	$	(422	)	Other liabilities

The table below identifies the gains and losses recognized on Heartland's embedded conversion options for the three- and nine-month periods ended September 30, 2017, and September 30, 2016, in thousands:



	Amount of Gain (Loss)		Income Statement Category
Three Months Ended September 30, 2017
Embedded conversion option	$	285	Other noninterest income
Nine Months Ended September 30, 2017
Embedded conversion option	$	422	Other noninterest income
Three Months Ended September 30, 2016
Embedded conversion option	$	435	Other noninterest income
Nine Months Ended September 30, 2016
Embedded conversion option	$	138	Other noninterest income

Back-to-Back Loan Swaps

Heartland has interest rate swap loan relationships with customers to meet their financing needs. Upon entering into these loan swaps, Heartland enters into offsetting positions with counterparties in order to minimize interest rate risk. These back-to-back loan swaps qualify as free standing financial derivatives with the fair values reported in other assets and other liabilities on the consolidated balance sheets. Heartland was required to post $2.0 million and $1.8 million at both September 30, 2017, and December 31, 2016, respectively, as collateral related to these back-to-back swaps. Heartland's counterparties were required to pledge $190,000 at September 30, 2017, and $768,000 at December 31, 2016. Any gains and losses on these back-to-back swaps are recorded in noninterest income on the consolidated statements of income, and for the nine months ended September 30, 2017 and September 30, 2016, no gain or loss was recognized. The table below identifies the balance sheet category and fair values of Heartland's derivative instruments designated as loan swaps at September 30, 2017, and December 31, 2016, in thousands:



	Notional Amount		Fair Value			Balance Sheet Category	Weighted Average Receive Rate		Weighted Average Pay Rate
September 30, 2017
Customer interest rate swaps	$	90,370	$	1,906		Other assets	4.75	%	3.91	%
Customer interest rate swaps	90,370		(1,906		)	Other liabilities	3.91	%	4.75	%
December 31, 2016
Customer interest rate swaps	$	69,594	$	1,588		Other assets	4.66	%	3.47	%
Customer interest rate swaps	69,594		(1,588		)	Other liabilities	3.47	%	4.66	%

Other Free Standing Derivatives

Heartland has entered into interest rate lock commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans and mortgage backed securities that are considered derivative instruments. Heartland enters into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future changes in interest rates on the commitments to fund the loans as well as on residential mortgage loans available for sale. The fair value of these commitments is recorded on the consolidated balance sheets, with the changes in fair value recorded in the consolidated statements of income as a component of gains on sale of loans held for sale. These derivative contracts are designated as free standing derivative contracts and are not designated against specific assets and liabilities on the consolidated balance sheets or forecasted transactions and therefore do not qualify for hedge accounting treatment. Heartland was required to pledge collateral of $353,000 at September 30, 2017, and $0 at December 31, 2016. Heartland's counterparties were required to pledge $29,000 and $2.9 million at September 30, 2017, and December 31, 2016, respectively, as collateral for these forward commitments.

Heartland acquired undesignated interest rate swaps in 2015. These swaps were entered into primarily for the benefit of customers seeking to manage their interest rate risk and are not designated against specific assets or liabilities on the consolidated balance sheet or forecasted transactions and therefore do not qualify for hedge accounting in accordance with ASC 815. These swaps are carried at fair value on the consolidated balance sheets as a component of other liabilities, with changes in the fair value recorded as a component of other noninterest income.

The table below identifies the balance sheet category and fair values of Heartland's other free standing derivative instruments not designated as hedging instruments at September 30, 2017, and December 31, 2016, in thousands:



	Balance Sheet Category	Notional Amount		Fair Value
September 30, 2017
Interest rate lock commitments (mortgage)	Other assets	$	77,910	$	2,463
Forward commitments	Other assets	75,192		237
Forward commitments	Other liabilities	91,865		(261		)
Undesignated interest rate swaps	Other liabilities	14,175		(923		)
December 31, 2016
Interest rate lock commitments (mortgage)	Other assets	$	80,465	$	2,790
Forward commitments	Other assets	142,750		2,546
Forward commitments	Other liabilities	59,276		(266		)
Undesignated interest rate swaps	Other liabilities	15,564		(1,126		)

The table below identifies the income statement category of the gains and losses recognized in income on Heartland's other free standing derivative instruments not designated as hedging instruments for the three- and nine-month periods ended September 30, 2017, and September 30, 2016, in thousands:



	Income Statement Category	Gain (Loss) Recognized
Three Months Ended September 30, 2017
Interest rate lock commitments (mortgage)	Net gains on sale of loans held for sale	$	(1,245	)
Forward commitments	Net gains on sale of loans held for sale	72
Undesignated interest rate swaps	Other noninterest income	88
Nine Months Ended September 30, 2017
Interest rate lock commitments (mortgage)	Net gains on sale of loans held for sale	$	(587	)
Forward commitments	Net gains on sale of loans held for sale	(2,304		)
Undesignated interest rate swaps	Other noninterest income	203
Three Months Ended September 30, 2016
Interest rate lock commitments (mortgage)	Net gains on sale of loans held for sale	$	(1,344	)
Forward commitments	Net gains on sale of loans held for sale	931
Undesignated interest rate swaps	Other noninterest income	269
Nine Months Ended September 30, 2016
Interest rate lock commitments (mortgage)	Net gains on sale of loans held for sale	$	4,464
Forward commitments	Net gains on sale of loans held for sale	(1,311		)
Undesignated interest rate swaps	Other noninterest income	(101		)