Accounting guidance requires that all derivatives be recognized in the consolidated financial statements at their fair values. On the date that the derivative contract is entered into, the Company designates the derivative as a hedge of variable cash flows to be paid or received in conjunction with recognized assets or liabilities as a cash flow or fair value hedge. For a derivative treated as a cash flow hedge, the ineffective portion of changes in fair value is reported in current period earnings. The effective portion of the cash flow hedge is recorded as an adjustment to the hedged item through other comprehensive income (loss). For a derivative treated as a fair value hedge, the gain or loss on the derivative as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in interest income. The Company uses interest rate swaps to reduce interest rate risk and to manage net interest income.

The Company formally assesses, both at the hedges’ inception, and on an on-going basis, whether derivatives used in hedging transactions have been highly effective in offsetting changes in cash flows of hedged items and whether those derivatives are expected to remain highly effective in subsequent periods. The Company discontinues hedge accounting when (i) it determines that a derivative is no longer effective in offsetting changes in cash flows of a hedged item; (ii) the derivative expires or is sold, terminated or exercised; (iii) probability exists that the forecasted transaction will no longer occur; or (iv) management determines that designating the derivative as a hedging instrument is no longer appropriate. In all cases in which hedge accounting is discontinued and a derivative remains outstanding, the Company will carry the derivative at fair value, recognizing changes in fair value in current period income in the consolidated statements of operations. There was no cash flow hedge ineffectiveness identified during 2018, 2017 and 2016.

Interest differentials paid or received under the swap agreements are reflected as adjustments to interest income. These interest rate swap agreements include both cash flow and fair value hedge derivative instruments that qualify for hedge accounting. The notional amounts of the interest rate swaps are not exchanged and do not represent exposure to credit loss. In the event of default by a counter party, the risk in these transactions is the cost of replacing the agreements at current market rates.

The Company entered into an interest rate swap agreement on July 1, 2010 to manage the interest rate exposure on its Junior Subordinated Debt due 2036. By entering into this agreement, the Company converts a floating rate liability into a fixed rate liability through 2020. Under the terms of the agreement, the Company receives interest quarterly at the rate equivalent to three-month LIBOR plus 1.70% repricing every three months on the same date as the Company’s Junior Subordinated Debt due 2036 and pays interest expense monthly at the fixed rate of 4.03%. The interest expense on the interest rate swap was $43,000, $82,000 and $103,000 for the years ended December 31, 2018, 2017 and 2016, respectively. In addition, on June 24, 2016, the Company entered into a forward interest rate swap agreement to convert the floating rate liability on the same Junior Subordinated Debt to fixed from 2020 to 2031. There was no interest expense recognized on the forward interest rate swap in 2018, and there will be no exchange of payments until 2020. Both of these swaps are designated as cash flow hedges and changes in the fair value are recorded as an adjustment through other comprehensive income (loss).

The Company entered into two swap agreements to manage the interest rate risk related to two commercial loans. The agreements allow the Company to convert fixed rate assets to floating rate assets through 2022 and 2025. The Company receives interest monthly at the rate equivalent to one-month LIBOR plus a spread repricing on the same date as the loans and pays interest at fixed rates. Interest income recognized on the interest rate swaps was $5,000 in 2018 and interest expense was $47,000 and $89,000 in 2017 and 2016, respectively, and is recorded in loan interest income. These swaps are designated as fair value hedges and changes in fair value are recorded in current earnings.

Cash collateral held at other banks for these swaps was $430,000 and $1.2 million at December 31, 2018 and 2017, respectively. Collateral posted and received is dependent on the market valuation of the underlying hedges.

The effects of derivative instruments on the consolidated financial statements for December 31, 2018 and 2017 are as follows:

(In thousands)

December 31, 2018

Derivatives designated as hedging instruments

Notional/Contract Amount

Fair Value

Balance Sheet Location

Expiration Date

Interest rate swap - cash flow

4,000

(38

)

Other Liabilities

9/15/2020

Interest rate forward swap - cash flow

4,000

255

Other Assets

6/15/2031

Interest rate swap - fair value

1,186

Other Assets

4/9/2025

Interest rate swap - fair value

4,347

Other Assets

2/12/2022

(In thousands)

December 31, 2017

Derivatives designated as hedging instruments

Notional/Contract Amount

Fair Value

Balance Sheet Location

Expiration Date

Interest rate swap - cash flow

4,000

(119

)

Other Liabilities

9/15/2020

Interest rate forward swap - cash flow

4,000

164

Other Assets

6/15/2031

Interest rate swap - fair value

1,219

Other Assets

4/9/2025

Interest rate swap - fair value

4,475

Other Assets

2/12/2022