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Note 8. Other Derivatives

9 Months Ended

Sep. 30, 2019

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Note 8. Other Derivatives

The Company is exposed to certain risk 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 and the use of derivative financial instruments.

Cash Flow Hedges of Interest Rate Risk

The Company uses interest rate swap agreements to assist in its interest rate risk management. The Company’s objective in using interest rate derivatives designated as cash flow hedges is to add stability to interest expense and to better manage its exposure to interest rate movements. To accomplish this objective, the Company utilizes interest rate swaps as part of its interest rate risk management strategy intended to mitigate the potential risk of rising interest rates on the Bank’s cost of funds. The notional amounts of the interest rate swaps designated as cash flow hedges do not represent amounts exchanged by the counterparties, but rather, the notional amount is used to determine, along with other terms of the derivative, the amounts to be exchanged between the counterparties. The interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from one counterparty in exchange for the Company making fixed payments. The Company’s intent is to hedge its exposure to the variability in potential future interest rate conditions on existing financial instruments.

For derivatives designated as cash flow hedges, changes in the fair value of the derivative are initially reported in other comprehensive income (outside of earnings), net of tax, and subsequently reclassified to earnings when the hedged transaction affects earnings. The Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions.

As of September 30, 2019, the Company had one designated cash flow hedge notional interest rate swap transaction outstanding amounting to $100 million associated with the Company’s variable rate deposits, as compared to three designated cash flow hedge notional interest rate swap transactions outstanding as of December 31, 2018 amounting to $250 million associated with the Company’s variable rate deposits. The decline in the amount of hedged variable rate deposits was due to a reduction in such variable rate deposits. The net unrealized loss before income tax on the swap was $362 thousand at September 30, 2019 compared to a net unrealized gain before income tax of $3.7 million at December 31, 2018. The unrealized loss in value since year end 2018 was due to the termination of two of the interest rate swap transactions as part of the Company’s asset liability strategy as well as declines in market interest rates. As a result of the swap terminations, the Company recognized $829 thousand in noninterest income during March 2019. Additionally, the Company will amortize $248 thousand of realized gain as a reduction to interest expense through the swap’s original maturity date of March 31, 2020.

Amounts reported in accumulated other comprehensive income related to designated cash flow hedge derivatives will be reclassified to interest income/expense as interest payments are made/received on the Company’s variable-rate assets/liabilities. During the quarter ended September 30, 2019, the Company reclassified $264 thousand related to designated cash flow hedge derivatives from accumulated other comprehensive income to decrease interest expense. During the next twelve months, the Company estimates (based on existing interest rates) that $134 thousand will be reclassified as an increase in interest expense.

Non-designated Hedges

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate caps and swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives 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 derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

The Company entered into credit risk participation agreements (“RPAs”) with institutional counterparties, under which the Company assumes its pro-rata share of the credit exposure associated with a borrower’s performance related to interest rate derivative contracts. The fair value of RPAs is calculated by determining the total expected asset or liability exposure of the derivatives to the borrowers and applying the borrowers’ credit spread to that exposure. Total expected exposure incorporates both the current and potential future exposure of the derivatives, derived from using observable inputs, such as yield curves and volatilities.

Credit-risk-related Contingent Features

The Company has agreements with each of its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, then the Company could also be declared in default on its derivative obligations.

The Company is exposed to credit risk in the event of nonperformance by the interest rate derivative counterparty. The Company minimizes this risk by entering into derivative contracts with only large, stable financial institutions, and the Company has not experienced, and does not expect, any losses from counterparty nonperformance on the interest rate derivatives. The Company monitors counterparty risk in accordance with the provisions of ASC Topic 815, “Derivatives and Hedging.” In addition, the interest rate derivative agreements contain language outlining collateral-pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits.

The interest rate derivative agreements detail: 1) that collateral be posted when the market value exceeds certain threshold limits associated with the secured party’s exposure; 2) 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; 3) if the Company 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.

As of September 30, 2019, the aggregate fair value of derivative contracts with credit risk contingent features (i.e., containing collateral posting or termination provisions based on our capital status) that was in a net liability position totaled $362 thousand. The Company has a minimum collateral posting threshold with its derivative counterparty. As of September 30, 2019, the Company was not required to post collateral with its derivative counterparty against its obligations under this agreement. If the Company had breached any provisions under the agreement at September 30, 2019, it could have been required to settle its obligations under the agreement at the termination value.

The table below identifies the balance sheet category and fair value of the Company’s designated cash flow hedge derivative instruments and non-designated hedges as of September 30, 2019 and December 31, 2018.

September 30, 2019 December 31, 2018

Notional Balance Sheet Notional Balance Sheet

Amount Fair Value Category Amount Fair Value Category

Derivatives designated as hedging instruments

(dollars in thousands)

Interest rate product $ —   $ —   Other Assets $ 250,000 $ 3,727 Other Assets

(dollars in thousands)

Interest rate product $ 100,000 $ 348 Other Liabilities $ —   $ —   Other Liabilities

Derivatives not designated as hedging instruments

(dollars in thousands)

Interest rate product $ 26,000 $ 15

Interest rate product 26,517 213

Interest rate product $ 52,517 $ 228 Other Assets $ —   $ —   Other Assets

(dollars in thousands)

Interest rate product $ 26,000 $ 15 Other Liabilities $ —   $ —   Other Liabilities

Interest rate product 26,517 220 Other Liabilities

Other Contracts 27,500 117 Other Liabilities 27,500 59 Other Liabilities

$ 80,017 $ 352 Other Liabilities $ 27,500 $ 59 Other Liabilities

The table below presents the pre-tax net gains (losses) of the Company’s designated cash flow hedges for the three and nine months ended September 30, 2019 and 2018.

Derivatives in Subtopic 815-20 Hedging Relationships (dollars in thousands)	Amount of Gain or (Loss) Recognized in OCI on Derivative					Location of Gain or (Loss) Recognized from Accumulated Other Comprehensive Income into Income	Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income
	Three Months Ended September 30,						Three Months Ended September 30,
	2019			2018			2019		2018
Derivatives in Cash Flow Hedging Relationships
Interest Rate Products	$	(107	)	$	849	Interest Expense	$	264	$	214
Total	$	(107	)	$	849		$	264	$	214

Derivatives in Subtopic 815-20 Hedging Relationships
(dollars in thousands) Amount of Gain or (Loss)
Recognized
in OCI on Derivative Location of Gain or (Loss)
Recognized from
Accumulated
Other Comprehensive
Income into Income Amount of Gain or (Loss)
Reclassified from
Accumulated
OCI into Income

Nine Months Ended September 30, Nine Months Ended September 30,

2019 2018 2019 2018

Derivatives in Cash Flow Hedging Relationships

Interest Rate Products $ (1,974 ) $ 4,401 Interest Expense $ 1,039 $ 230

Interest Rate Products — — Gain on sale of investment securities 829 —

Total $ (1,974 ) $ 4,401 $ 1,868 $ 230

The table below presents the effect of the Company’s derivative financial instruments on the Consolidated Statements of Operations for the three and nine months ended September 30, 2019 and 2018.

The Effect of Fair Value and Cash Flow Hedge Accounting on the Statement of Financial Performance

Location and Amount of Gain or (Loss) Recognized in Income on Fair Value

and Cash Flow Hedging Relationships (in 000's)

Three Months Ended September 30, Nine Months Ended September 30,

2019 2018 2019 2019 2018

Interest Expense Interest Expense Gain on sale of
investment
securities Interest Expense

Total amounts of income and expense line items presented in the statement of financial performance in which the effects of fair value or cash flow hedges are recorded $ 264 $ 214 $ 1,039 $ 829 $ 16

Gain or (loss) on cash flow hedging relationships in Subtopic 815-20

Interest contracts

Amount of gain or (loss) reclassified from accumulated other  comprehensive income into income $ 264 $ 214 $ 1,039 $ —   $ 230

Amount of gain or (loss) reclassified from accumulated other comprehensive income into income as a result that a forecasted transaction is no longer probable of occurring $ —   $ —   $ —   $ 829 $ —

Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income -  Included Component $ 264 $ 214 $ 1,039 $ 829 $ 230

Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income -  Excluded Component $ — $ — $ — $ — $ —

Effect of Derivatives Not Designated as Hedging Instruments on the Statement of Financial Performance
Derivatives Not Designated as Hedging Instruments under Subtopic 815-20	Location of Gain or (Loss) Recognized in Income on Derivative	Amount of Gain or (Loss) Recognized in Income on Derivative					Amount of Gain or (Loss) Recognized in Income on Derivative
		Three Months Ended September 30,					Nine Months Ended September 30,
		2019			2018		2019			2018

Interest Rate Products	Other income / (expense)		(7	)				(7	)
Other Contracts	Other income / (expense)		(16	)		—		(58	)		—
Total			(23	)		—		(65	)		—

Balance Sheet Offsetting: Our designated cash flow hedge interest rate derivatives are eligible for offset in the Consolidated Balance Sheets and are subject to master netting arrangements. Our derivative transactions with counterparties are generally executed under International Swaps and Derivative Association (“ISDA”) master agreements which include “right of set-off” provisions. In such cases there is generally a legally enforceable right to offset recognized amounts and there may be an intention to settle such amounts on a net basis. The Company generally offsets such financial instruments for financial reporting purposes.

The table below presents a gross presentation, the effects of offsetting, and a net presentation of the Company’s cash flow hedge derivatives as of September 30, 2019 and December 31, 2018.

As of September 30, 2019

Offsetting of Derivative Assets (dollars in thousands) Gross Amounts Not Offset in the Balance Sheet

Gross Amounts of
Recognized Assets Gross Amounts
Offset in the
Balance Sheet Net Amounts of
Assets presented
in the
Balance Sheet Financial Instruments Cash Collateral Posted Net Amount

Derivatives $ 228 $ — $ 228 $ — $ — $ 228

Offsetting of Derivative Liabilities (dollars in thousands)							Gross Amounts Not Offset in the Balance Sheet
	Gross Amounts of Recognized Liabilities		Gross Amounts Offset in the Balance Sheet		Net Amounts of Liabilities presented in the Balance Sheet		Financial Instruments		Cash Collateral Posted		Net Amount
Derivatives	$	669	$	—	$	669	$	—	$	—	$	669

As of December 31, 2018

Offsetting of Derivative Assets (dollars in thousands) Gross Amounts Not Offset in the Balance Sheet

Gross Amounts of
Recognized Assets Gross Amounts
Offset in the
Balance Sheet Net Amounts of
Assets presented in
the Balance Sheet Financial Instruments Cash Collateral Posted Net Amount

Derivatives $ 3,840 $ — $ 3,840 $ — $ — $ 3,840

Offsetting of Derivative Liabilities (dollars in thousands)							Gross Amounts Not Offset in the Balance Sheet
	Gross Amounts of Recognized Liabilities		Gross Amounts Offset in the Balance Sheet		Net Amounts of Liabilities presented in the Balance Sheet		Financial Instruments		Cash Collateral Posted		Net Amount
Derivatives	$	59	$	—	$	59	$	—	$	—	$	59