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Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions
 9 Months Ended
Sep. 30, 2015
Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions  
Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions

Note 13 – Financial Instruments with Off-Balance Sheet Risk and Derivative Transactions

 

To meet the financing needs of its customers, the Bank, as a subsidiary of the Company, is a party to various financial instruments with off-balance-sheet risk in the normal course of business.  These off-balance-sheet financial instruments include commitments to originate and sell loans as well as financial standby, performance standby and commercial letters of credit.  The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.  The Bank’s exposure to credit loss for loan commitments and letters of credit is represented by the dollar amount of those instruments.  Management generally uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments.

 

Interest Rate Swap Designated as a Cash Flow Hedge

 

The Company entered into a forward starting interest rate swap on August 18, 2015, with an effective date of June 15, 2017.  This transaction had a notional amount totaling $25.8 million as of September 30, 2015, was designated as a cash flow hedge of certain junior subordinated debentures and was determined to be fully effective during the period presented.  As such, no amount of ineffectiveness has been included in net income.  Therefore, the aggregate fair value of the swap is recorded in other assets with changes in fair value recorded in other comprehensive income.  The amount included in other comprehensive income would be reclassified to current earnings should all or a portion of the hedge no longer be considered effective.  The Company expects the hedge to remain fully effective during the remaining term of the swap.  The Bank will pay the counterparty a fixed rate and receive a floating rate based on three month LIBOR.  Management concluded that it would be advantageous to enter this transaction given that the Company has trust preferred securities that will change from fixed rate to floating rate on June 15, 2017.  The cash flow hedge has a maturity date of June 15, 2037.

 

Summary information about the interest rate swap designated as a cash flow hedge is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

As of

 

 

September 30, 2015

 

December 31, 2014

Notional amount

 

$
25,774

 

 

$

 -

 

Unrealized loss

 

 
(816)

 

 

 

 -

 

 

Other Interest Rate Swaps

 

The Bank also has interest rate derivative positions to assist with risk management that are not designated as hedging instruments.  These derivative positions relate to transactions in which the Bank enters an interest rate swap with a client (or in the case above the Company) while at the same time entering into an offsetting interest rate swap with another financial institution.  Per contractual requirements with the correspondent financial institution, the Bank had $2.0 million in investment securities pledged to support interest rate swap activity with two correspondent financial institutions at September 30, 2015.  The Bank had $3.0 million in investment securities pledged to support interest rate swap activity with three correspondent financial institutions at December 31, 2014.

 

In connection with each transaction, the Bank agreed to pay interest to the client on a notional amount at a variable interest rate and receive interest from the client on the same notional amount at a fixed interest rate.  At the same time, the Bank agreed to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount.  The transaction allows the client to convert a variable rate loan to a fixed rate loan and is part of the Company’s interest rate risk management strategy.  Because the Bank acts as an intermediary for the client, changes in the fair value of the underlying derivative contracts offset each other and do not generally affect the results of operations.  Fair value measurements include an assessment of credit risk related to the client’s ability to perform on their contract position, however, and valuation estimates related to that exposure are discussed in Note 12 above.  At September 30, 2015, the notional amount of non-hedging interest rate swaps was $17.7 million with a weighted average maturity of 4.5 years.  At December 31, 2014, the notional amount of non-hedging interest rate swaps was $16.3 million with a weighted average maturity of 2.7 years.  The Bank offsets derivative assets and liabilities that are subject to a master netting arrangement.

 

The Bank also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards.  The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts.  Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue.  Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.

 

The following table presents derivatives not designated as hedging instruments as of September 30, 2015, and periodic changes in the values of the interest rate swaps are reported in other noninterest income.  Periodic changes in the value of the forward contracts related to mortgage loan origination are reported in the net gain on sales of mortgage loans.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Asset Derivatives

 

Liability Derivatives

 

 

Notional or

 

 

 

 

 

 

 

 

 

 

Contractual

 

Balance Sheet

 

 

 

 

Balance Sheet

 

 

 

 

    

Amount

    

Location

    

Fair Value

    

Location

    

Fair Value

Interest rate swap contracts

 

$
17,670

 

Other Assets

 

$
157

 

Other Liabilities

 

$
157

Commitments1

 

 
231,466

 

Other Assets

 

 
230

 

N/A

 

 

 -

Forward contracts2

 

 
19,000

 

N/A

 

 

 -

 

Other Liabilities

 

 

 -

Total

 

 

 

 

 

 

$
387

 

 

 

$
157

 

1Includes unused loan commitments and interest rate lock commitments.

2Includes forward MBS contracts and forward loan contracts.

 

The following table presents derivatives not designated as hedging instruments as of December 31, 2014.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Asset Derivatives

 

Liability Derivatives

 

 

Notional or

 

 

 

 

 

 

 

 

 

 

Contractual

 

Balance Sheet

 

 

 

 

Balance Sheet

 

 

 

 

    

Amount

    

Location

    

Fair Value

    

Location

    

Fair Value

Interest rate swap contracts net of credit valuation

 

$
16,334

 

Other Assets

 

$
30

 

Other Liabilities

 

$
30

Commitments1

 

 
201,946

 

Other Assets

 

 
143

 

N/A

 

 

 -

Forward contracts2

 

 
14,000

 

N/A

 

 

 -

 

Other Liabilities

 

 

 -

Total

 

 

 

 

 

 

$
173

 

 

 

$
30

 

1Includes unused loan commitments and interest rate lock commitments.

2Includes forward MBS contracts.

 

The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party.  The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers.  In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO.  The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2015, and December 31, 2014.

 

The following table is a summary of letter of credit commitments (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2015

 

December 31, 2014

 

 

    

Fixed

    

Variable

    

Total

    

Fixed

    

Variable

    

Total

  

Letters of credit:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Borrower:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial standby

 

$
55

 

$
3,497

 

$
3,552

 

$
55

 

$
4,745

 

$
4,800

 

Commercial standby

 

 

 -

 

 
47

 

 
47

 

 

 -

 

 
49

 

 
49

 

Performance standby

 

 
404

 

 
7,350

 

 
7,754

 

 
416

 

 
5,690

 

 
6,106

 

 

 

 
459

 

 
10,894

 

 
11,353

 

 
471

 

 
10,484

 

 
10,955

 

Non-borrower:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Performance standby

 

 

 -

 

 
575

 

 
575

 

 

 -

 

 
572

 

 
572

 

 

 

 

 -

 

 
575

 

 
575

 

 

 -

 

 
572

 

 
572

 

Total letters of credit

 

$
459

 

$
11,469

 

$
11,928

 

$
471

 

$
11,056

 

$
11,527