Derivatives and Hedging Activities

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 may also, at times, use derivative financial instruments. Specifically, the Company may enter into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and unknown cash amounts, the value of which are determined by interest rates.

The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the earnings effect of the hedged forecasted transactions in a cash flow hedge. For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income (“AOCI”), net of tax and subsequently reclassified into interest income or interest expense in the same period during which the hedged transaction affects earnings. Amounts reported in AOCI related to cash flow hedge derivatives will be reclassified to interest expense as interest payments are made on the Company’s hedge liability or interest income as interest payments are made on the Company's hedge asset. See Note 10, “Other Comprehensive Income (Loss),” of this Form 10-Q for additional information related to the cash flow hedges impact on the Company’s AOCI and Consolidated Statement of Income.

The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply, or the Company elects not to apply hedge accounting. Back-to-Back swaps are not speculative; rather, the transactions result from a service the Company provides to certain commercial customers. Back-to-Back swaps do not meet hedge accounting requirements and therefore changes in the fair value of both the customer swaps and the counterparty swaps, which have an offsetting relationship, are recognized directly in earnings.

The Company records all derivatives on the balance sheet at fair value. Asset derivatives are included in the line item "Prepaid expenses and other assets," and liability derivatives are included in the "Accrued expenses and other liabilities" line item on the Consolidated Balance Sheets, respectively. In accordance with GAAP, the Company elects to measure the credit risk of its derivative financial instruments that are subject to master netting agreements by derivative type on a net basis by counterparty portfolio.

The tables below presents a summary of the Company's derivative financial instruments, notional amounts and fair values for the periods presented:



	As of March 31, 2020
(Dollars in thousands)	Asset Notional Amount		Asset Derivatives⁽¹⁾		Liability Notional Amount		Liability Derivatives⁽¹⁾
Derivatives designated as hedging instruments
Interest-rate contracts - pay fixed, receive floating	$	—	$	—	$	75,000	$	2,869
Total cash flow hedge interest-rate swaps	$	—	$	—	$	75,000	$	2,869

Derivatives not subject to hedge accounting
Interest-rate contracts - pay floating, receive fixed	$	43,806	$	3,547	$	—	$	—
Interest-rate contracts - pay fixed, receive floating	—		—		43,806		3,547
Total back-to-back interest-rate swaps	$	43,806	$	3,547	$	43,806	$	3,547



	December 31, 2019
(Dollars in thousands)	Asset Notional Amount		Asset Derivatives⁽¹⁾		Liability Notional Amount		Liability Derivatives⁽¹⁾
Derivatives not subject to hedge accounting
Interest-rate contracts - pay floating, receive fixed	$	10,502	$	625	$	12,273	$	187
Interest-rate contracts - pay fixed, receive floating	—		—		22,775		438
Total back-to-back interest-rate swaps	$	10,502	$	625	$	35,048	$	625

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(1)	Accrued interest balances related to the Company’s interest rate swaps are not included in the fair values above and are immaterial.

The Company had no derivative fair value hedges at either March 31, 2020 or December 31, 2019.

Cash flow Hedges

Interest-rate swap agreements may be entered into as hedges against future interest-rate fluctuations on specifically identified assets or liabilities. The Company’s cash flow hedges are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s borrowings.

The Company’s objectives in using these interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, during the first quarter of 2020, the Company entered into three pay fixed, receive float interest rate swaps to hedge the variable cash flows associated with short-term borrowings. Each swap has a notional value of $25.0 million with respective maturities of three years, four years and five years. At March 31, 2020, these interest rate swaps are designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

In relation to the Company's cash flow hedges, the Company estimates that an additional $605 thousand (pre-tax) will be reclassified out of AOCI as an increase to interest expense during the next twelve months.

Back-to-back swaps

The Company has a "Back-to-Back Swap" program whereby the Bank enters into an interest-rate swap with a qualified commercial banking customer and simultaneously enters into an equal and opposite interest-rate swap with a swap counterparty. The customer interest-rate swap agreement allows commercial banking customers to convert a floating-rate loan payment to a fixed-rate payment.

Each Back-to-Back swap consists of two interest-rate swaps (a customer swap and offsetting counterparty swap) and amounted to a total number of 12 and 10 interest-rate swaps outstanding at March 31, 2020 and December 31, 2019, respectively. The transaction structure effectively minimizes the Bank's interest rate risk exposure resulting from such transactions. Customer-related credit risk is minimized by the cross collateralization of the loan and the interest-rate swap agreement to the customer's underlying collateral.

Interest-rate swaps with the counterparty are subject to master netting agreements, while interest-rate swaps with customers are not. As a result of this offsetting relationship, there were no net gains or losses recognized in income on Back-to-Back swaps during the three months ended March 31, 2020 or March 31, 2019.

At March 31, 2020, all of the Back-to-Back swaps with the counterparty were in the same liability position, therefore there was no netting reflected in the Company’s Consolidated Balance Sheet. The table below presents at December 31, 2019, the Company's liability derivative positions and the potential effect of those netting arrangements on its financial position. As noted above, interest-rate swaps with customers are not subject to master netting agreements and therefore are not included in the table below.



	As of December 31, 2019
(Dollars in thousands)	Gross Amounts of Recognized Liabilities		Gross Amounts Offset in the Consolidated Balance Sheet		Net Amounts of Liabilities Presented in the Consolidated Balance Sheet
Liabilities Derivatives
Interest-rate contracts - pay fixed, receive floating	$	625	$	187	$	438

Credit Risk

By using derivative financial instruments, the Company exposes itself to counterparty-credit risk. Credit risk is the risk of failure by the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes the Company, which creates credit risk for the Company. When the fair value of a derivative is negative, the Company owes the counterparty and, therefore, it does not possess credit risk. The credit risk in derivative instruments is mitigated by entering into transactions with highly-rated counterparties that management believes to be creditworthy. Additionally, counterparty interest rate swaps contain provisions for collateral to be posted if the derivative exposure exceeds a threshold amount.

The Company has one counterparty and it was rated A and A2 by Standard & Poor's and Moody's, respectively, at March 31, 2020. The Company had no credit risk exposure at either March 31, 2020 or December 31, 2019 relating to interest-rate swaps with counterparties. When the Company has credit risk exposure, collateral is received from the counterparty and held by the Company. Collateral held by the Company is restricted and not considered an asset of the Company. Therefore, it is not carried on the Company's Consolidated Balance Sheet. If the Company posts collateral, the cash is restricted, is considered an asset of the Company and is carried on the Company's Consolidated Balance Sheet. The Company posted cash collateral of $6.6 million and $850 thousand at March 31, 2020 and December 31, 2019, respectively.

Credit-risk-related Contingent Features

The Company's interest-rate swaps with counterparties contain credit-risk-related contingent provisions. These provisions provide the counterparty with the right to terminate its derivative positions and require the Company to settle its obligations under the agreements if the Company defaults on certain of its indebtedness.

As of March 31, 2020, the fair value of derivatives in a net liability position, which excludes any adjustment for nonperformance risk, related to these agreements was $6.4 million. The Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral at March 31, 2020 as noted above.

Other Derivative Related Activity

The Company also participates in loans originated by third party banks, where the originating bank utilizes a back-to-back interest-rate swap structure; however, the Company is not a party to the swap agreements. Under the terms of the loan participations, the Company has accepted contingent liabilities that would only be realized if the swaps were terminated early and there were outstanding losses not covered by the underlying borrowers and the borrowers' pledged collateral. If applicable, the Company's swap-loss exposure would be equal to a percentage of the originating bank's swap loss based on the ratio of the Company's loan participation to the underlying loan. At both March 31, 2020 and December 31, 2019, the Company had one participation loan where the originating bank utilizes a back-to-back interest-rate swap structure. At March 31, 2020, management considers the risk of material swap-loss exposure related to this participation loan to be unlikely based on the borrower's financial and collateral strength. Management continues to closely monitor for credit changes resulting from the COVID-19 pandemic.

Interest-rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments. The commitments to sell loans are also considered derivative instruments. The Company generally does not pool mortgage loans for sale, but instead sells the loans on an individual basis. To reduce the net interest-rate exposure arising from its loan sale activity, the Company enters into the commitment to sell these loans at essentially the same time that the interest-rate lock commitment is quoted on the origination of the loan. The Company estimates the fair value of these derivatives based on current secondary mortgage market prices. At March 31, 2020 and December 31, 2019, the estimated fair value of the Company's interest-rate lock commitments and commitments to sell these mortgage loans were deemed immaterial.