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Interest Rate Swap Derivatives

12 Months Ended

Dec. 31, 2019

Note 10 – Interest Rate Swap 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 December 31, 2019 and 2018, the Company had one and three designated cash flow hedge interest rate swap transactions outstanding, respectively, associated with the Company's variable rate deposits. The Company recognized $829 thousand in noninterest income during March 2019 due to the termination of two of its interest rate swap transactions as part of the Company’s asset liability strategy as well as declines in market interest rates.

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 next twelve months, the Company estimates (based on existing interest rates) that $12 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 swap 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 designated 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; and 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 December 31, 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 $515 thousand. The aggregate fair value of all derivative contracts with credit risk contingent features that were a net asset position totaled $3.8 million as of December 31, 2018. The Company has minimum collateral posting thresholds with certain of its derivative counterparties. As of December 31, 2019 the Company posted $500 thousand with its derivative counterparties against its obligations under these agreements because these agreements were in a net liability position. At December 31, 2018, the Company was not required to post collateral with its derivative counterparties against its obligations under these agreements because these agreements were in a net asset position. If the Company had breached any provisions under the agreements at December 31, 2019 or December 31, 2018, it could have been required to settle its obligations under the agreements 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 December 31, 2019 and December 31, 2018.


	December 31, 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	$	3,840	Other Assets

(dollars in thousands)
Interest rate product	$	100,000	$	206	Other Liabilities	$	—	$	—	Other Liabilities

Derivatives not designated as hedging instruments

(dollars in thousands)
Interest rate product	$	26,000	$	10	Other Assets	$	—	$	—	Other Assets
Interest rate product		24,293		168	Other Assets		—		—	Other Assets
Interest rate product		6,513		133	Other Assets		—		—	Other Assets
	$	56,806	$	311	Other Assets	$	—	$	—	Other Assets

Derivatives not designated as hedging instruments

(dollars in thousands)
Interest rate product	$	26,000	$	10	Other Liabilities	$	—	$	—	Other Liabilities
Interest rate product		24,293		172	Other Liabilities		—		—	Other Liabilities
Interest rate product		6,513		137	Other Liabilities		—		—	Other Liabilities
Other Contracts		27,384		86	Other Liabilities		27,500		59	Other Liabilities
	$	84,190	$	405		$	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 years ended December 31, 2019 and December 31, 2018.


The Effect of Fair Value and Cash Flow Hedge Accounting on Accumulated Other Comprehensive Income
					Location of Gain or (Loss)
					Recognized from
					Accumulated Other	Amount of Gain or (Loss)
	Amount of Gain or (Loss) Recognized in OCI				Comprehensive Income into	Reclassified from Accumulated OCI
	on Derivative				Income	into Income
	Year Ended December 31,					Year Ended December 31,
Derivatives in Subtopic 815-20 Hedging Relationships (dollars in thousands)	2019		2018			2019		2018
Derivatives in Cash Flow Hedging Relationships
Interest Rate Products	$	(1,812)	$	2,070	Interest Expense	$	1,165	$	560
Total	$	(1,812)	$	2,070		$	1,165	$	560

					Location of Gain or (Loss)
					Recognized from
					Accumulated Other	Amount of Gain or (Loss)
	Amount of Gain or (Loss) Recognized in OCI				Comprehensive Income into	Reclassified from Accumulated OCI
	on Derivative				Income	into Income
	Year Ended December 31,					Year Ended December 31,
Derivatives in Subtopic 815-20 Hedging Relationships (dollars in thousands)	2019		2018			2019		2018
Derivatives in Cash Flow Hedging Relationships
Interest Rate Products	$	(1,812)	$	2,070	Interest Expense	$	1,165	$	560
Interest Rate Products		—		—	Gain on sale of investment securities		829		—
Total	$	(1,812)	$	2,070		$	1,994	$	560

The tables below present the effect of the Company’s derivative financial instruments on the Consolidated Statements of Operation for the years ended December 31, 2019 and 2018.


The Effect of Fair Value and Cash Flow Hedge Accounting on the Statements of Operation

	Year Ended December 31,
	2019		2019		2018
	Interest		Gain on sale of		Interest
	Expense		investment securities		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	$	1,165	$	829	$	560


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	$	1,165	$	—	$	560
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	$	1,165	$	829	$	560
Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income - Excluded Component	$	—	$	—	$	—


Effect of Derivatives Not Designated as Hedging Instruments on the Statements of Operation
		Amount of Gain or (Loss)
		Recognized in Income on
Derivatives Not Designated as	Location of Gain or	Derivative
Hedging Instruments under Subtopic	(Loss) Recognized in	Year Ended December 31,
815-20	Income on Derivative	2019	2018
Interest Rate Products	Other income / (expense)	(8)	—
Other Contracts	Other income / (expense)	(27)	—
Total		(35)	—

Balance Sheet Offsetting: Our designated cash flow hedge interest rate swap derivatives are eligible for offset in the Consolidated Balance Sheet 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 following table presents the liabilities subject to an enforceable master netting arrangement as of December 31, 2019 and December 31, 2018.

As of December 31, 2019

Net

Amounts of

Gross

Assets

Gross Amounts Not Offset in the

Gross

Amounts

presented

Balance Sheet

Amounts of

Offset in

in the

Cash

Recognized

the Balance

Balance

Financial

Collateral

Net

Offsetting of Derivative Assets (dollars in thousands)

Assets

Sheet

Instruments

Posted

Amount

311

—

311

—

311

Net

Amounts of

Gross

Liabilities

Gross Amounts Not Offset in the

Gross

Amounts

presented

Balance Sheet

Amounts of

Offset in

in the

Cash

Recognized

the Balance

Balance

Financial

Collateral

Net

Offsetting of Derivative Liabilities (dollars in thousands)

Liabilities

Sheet

Instruments

Posted

Amount

Derivatives

611

—

611

—

500

111

As of December 31, 2018

Net

Amounts of

Gross

Assets

Gross Amounts Not Offset in the

Gross

Amounts

presented

Balance Sheet

Amounts of

Offset in

in the

Cash

Recognized

the Balance

Balance

Financial

Collateral

Net

Offsetting of Derivative Assets (dollars in thousands)

Assets

Sheet

Instruments

Posted

Amount

Derivatives

3,840

—

3,840

—

3,840

Net

Amounts of

Gross

Liabilities

Gross Amounts Not Offset in the

Gross

Amounts

presented

Balance Sheet

Amounts of

Offset in

in the

Cash

Recognized

the Balance

Balance

Financial

Collateral

Net

Offsetting of Derivative Liabilities (dollars in thousands)

Liabilities

Sheet

Instruments

Posted

Amount

Derivatives

—