Note 8 – Derivatives and Hedging Activities

ChoiceOne is exposed to certain risks relating to its ongoing business operations. ChoiceOne utilizes interest rate derivatives as part of its asset liability management strategy to help manage its interest rate risk position. Derivative instruments represent contracts between parties that result in one party delivering cash to the other party based on a notional amount and an underlying term (such as a rate, security price or price index) as specified in the contract. The amount of cash delivered from one party to the other is determined based on the interaction of the notional amount of the contract with the underlying term. Derivatives are also implicit in certain contracts and commitments.

ChoiceOne recognizes derivative financial instruments in the consolidated financial statements at fair value regardless of the purpose or intent for holding the instrument. ChoiceOne records derivative assets and derivative liabilities on the balance sheet within other assets and other liabilities, respectively. Changes in the fair value of derivative financial instruments are either recognized in income or in shareholders’ equity as a component of accumulated other comprehensive income or loss depending on whether the derivative financial instrument qualifies for hedge accounting and, if so, whether it qualifies as a fair value hedge or cash flow hedge.

ChoiceOne currently uses interest rate swaps and interest rate caps to manage its exposure to certain fixed and variable rate assets and variable rate liabilities.

Interest rate swaps

ChoiceOne uses interest rate swaps as part of its interest rate risk management strategy to add stability to net interest income and to manage its exposure to interest rate movements. Interest rate swaps designated as hedges involve the receipt of variable-rate amounts from a counterparty in exchange for ChoiceOne making fixed-rate payments or the receipt of fixed-rate amounts from a counterparty in exchange for ChoiceOne making variable rate payments, over the life of the agreements without the exchange of the underlying notional amount.

In the second quarter of 2022, ChoiceOne entered into two pay-floating/receive-fixed interest rate swaps (the “Pay Floating Swap Agreements”) for a total notional amount of $200.0 million that were designated as cash flow hedges. These derivatives hedge the variable cash flows of specifically identified available-for-sale securities, cash and loans. The Pay Floating Swap Agreements were determined to be highly effective during the periods presented and therefore no amount of ineffectiveness has been included in net income. The Pay Floating Swap Agreements will pay a coupon rate equal to SOFR while receiving a fixed coupon rate of 2.41%.

Net cash settlements received for the twelve months ended December 31, 2022, on pay-floating/ received-fixed swaps were $161,000 as of December 31, 2022, which were included in interest income.

In the second quarter of 2022, ChoiceOne entered into one forward starting pay-fixed/receive-floating interest rate swap (the “Pay Fixed Swap Agreement”) for a notional amount of $200.0 million that was designated as a cash flow hedge. This derivative hedges the risk of variability in cash flows attributable to forecasted payments on future deposits or floating rate borrowings indexed to the SOFR Rate. The Pay Fixed Swap Agreement is two years forward starting with an eight-year term set to expire in 2032. The Pay Fixed Swap Agreements will pay a fixed coupon rate of 2.75% while receiving the SOFR Rate.

In the fourth quarter of 2022, ChoiceOne entered into four pay-fixed/receive-floating interest rate swaps for a total notional amount of $201.0 million that were designated as fair value hedges. These derivatives hedge the risk of changes in fair value of certain available for sale securities for changes in the SOFR benchmark interest rate component of the fixed rate bonds. All four of these hedges were effective immediately on December 22, 2022. Of the total notional value, $101.9 million has a ten-year term set to expire in 2032, with the benchmark SOFR interest rate risk component of the fixed rate bonds equal to 3.390%. Of the total notional value, $50.0 million has a nine-year term set to expire in 2031, with the benchmark SOFR interest rate risk component of the fixed rate bonds equal to 3.4015%. The remaining notional value of $49.1 million has a nine-year term set to expire in 2031, with the benchmark SOFR interest rate risk component of the fixed rate bonds equal to 3.4030%. ChoiceOne adopted ASC2022-01, as of December 20, 2022, to use the portfolio layer method. The fair value basis adjustment associated with an available-for-sale fixed rate bonds initially results in an adjustment to AOCI. For available-for-sale securities subject to fair value hedge accounting, the changes in the fair value of the fixed rate bonds related to the hedged risk (the benchmark interest rate component and the partial term) are then reclassed from AOCI to current earnings offsetting the fair value measurement change of the interest rate swap, which is also recorded in current earnings. Net cash settlements are received/paid semi-annually, with the first starting in March 2023, and will be included in interest income.

Subsequent to December 31, 2022, ChoiceOne terminated all pay-floating/receive-fixed (“pay floating swap agreements”) interest rate swaps with a notational amount of $200.0 million which resulted in a loss of $4.2 million. The pay floating swap agreements were designated as cash flow hedges against specifically identified available-for-sale securities, cash and loans. The loss was capitalized to available for sale securities and loans on the statement of financial condition and will be amortized into interest income over 13 months, or the remaining period of the agreements. Refer to footnote 23 for further discussion.

Interest rate caps

ChoiceOne also uses interest rate caps to provide stability to net interest income and to manage its exposure to interest rate movements. Interest rate caps designated as hedges involve the payment of a fixed premium by ChoiceOne who will then receive payments equivalent to the spread between the current rate and the strike rate until the conclusion of the term from the counterparty.

In the second quarter of 2022, ChoiceOne entered into four forward starting interest rate cap agreements with a total notional amount of $200.0 million (“SOFR Cap Agreements”). Three of the SOFR Cap Agreements with a total notional amount of $100.0 million are designated as fair value hedges and hedge against changes in the fair value of certain fixed rate tax-exempt municipal bonds. ChoiceOne utilizes the interest rate caps as hedges against adverse changes in interest rates on the designated securities attributable to fluctuations in the SOFR rate above 2.68%, as applicable. An increase in the benchmark interest rate hedged reduces the fair value of these assets. The remaining SOFR Cap Agreement with a notional amount of $100.0 million is designated as a cash flow hedge and hedges against the risk of variability in cash flows attributable to fluctuations in the SOFR rate above 2.68% for forecasted payments on future deposits or borrowings indexed to the SOFR Rate. All of the SOFR Cap Agreements are two-year forward starting with an eight-year term set to expire in 2032. The initial amount excluded from hedge effectiveness testing and amortized into earnings over the life of the interest rate cap derivatives is $16.5 million.

In the fourth quarter of 2022, ChoiceOne sold all four of the SOFR Cap Agreements for a total of $15,550,000, which resulted in a loss of $770,803. Of the total loss, $321,903 was related to the SOFR Cap Agreements designated as a cash flow hedge and recognized immediately in interest expense. The remaining loss of $448,900 was related to the SOFR Cap Agreements designated as fair value hedges and was capitalized to available for sale securities on the statement of financial condition and will be amortized into interest income over the weighted average life of the available for sale securities hedged.

The table below presents the fair value of derivative financial instruments as well as the classification within the consolidated statements of financial condition.

	December 31, 2022			December 31, 2021
(Dollars in thousands)	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Derivatives designated as hedging instruments
Interest rate contracts	Other Assets	$	9,204	Other Assets	$	-
Interest rate contracts	Other Liabilities	$	5,823	Other Liabilities	$	-

The table below presents the cumulative basis adjustments on hedged items designated as fair value hedges and the related amortized cost of those items as of the periods presented.

	Location and Amount of Gain or (Loss)						Location and Amount of Gain or (Loss)
	Recognized in Income on Fair Value and Cash Flow Hedging Relationships						Recognized in Income on Fair Value and Cash Flow Hedging Relationships
	Year Ended December 31, 2022						Year Ended December 31, 2021
(Dollars in thousands)	Interest Income			Interest Expense			Interest Income		Interest Expense
Total amounts of income and expense line items presented in the consolidated statements of income in which the effects of fair value or cash flow hedges are recorded	$	(55	)	$	(825	)	$	-	$	-

Gain or (loss) on fair value hedging relationships:

Hedged items	$	(1,930	)	$	-		$	-	$	-
Derivatives designated as hedging instruments	$	2,171		$	-		$	-	$	-
Amount excluded from effectiveness testing recognized in earnings based on amortization approach	$	(496	)	$	-		$	-	$	-

Gain or (loss) on cash flow hedging relationships:
Interest rate contracts:
Amount of gain or (loss) reclassified from accumulated other comprehensive income into income	$	-		$	-		$	-	$	-
Amount excluded from effectiveness testing recognized in earnings based on amortization approach	$	-		$	(503	)	$	-	$	-

The table below presents the effect of fair value and cash flow hedge accounting on the consolidated statements of operations for the periods presented.

			12/31/2022
			Cumulative amount of Fair
(Dollars in thousands)			Value Hedging Adjustment
Line Item in the Statement of			included in the carrying
Financial Position in which the	Amortized cost of the		amount of the Hedged
Hedged Item is included	Hedged Assets/(Liabilities)		Assets/(Liabilities)

Securities available for sale	$	225,851	$	1,930