DERIVATIVES

9 Months Ended

Sep. 30, 2022

DERIVATIVES

DERIVATIVES

10. DERIVATIVES

The Company’s derivative financial instruments 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 to manage the Company’s interest rate risk. Additionally, the Company enters into interest rate derivatives to accommodate the business requirements of its customers. All derivatives are recognized as either assets or liabilities on the balance sheet and are measured at fair value. The accounting for changes in the fair value of a derivative instrument depends upon whether or not it qualifies as a hedge for accounting purposes, and further, by the type of hedging relationship.

Interest Rate Swaps Designated as a Cashflow Hedge

As part of its interest rate risk management strategy, the Company utilizes interest rate swap agreements to help manage its interest rate risk positions. The notional amount of the interest rate swaps do not represent the amount exchanged by the parties. The exchange of cash flows is determined by reference to the notional amounts and the other terms of the interest rate swap agreements. The changes in fair value of derivatives designated as cashflow hedges are recorded in other comprehensive income and subsequently reclassified to earnings when gains or losses are realized.

As of September 30, 2022, the Company had one interest rate swap agreement with a notional amount of $100.0 million that was designated as a cashflow hedge of certificates of deposits. The interest rate swap agreement has an average maturity of 2.52 years, the current weighted average fixed rate paid is 0.67%, the weighted average 3-month LIBOR swap receive rate is 2.32%, and the fair value is $8.7 million. The Company expects approximately $3.7 million related to the cashflow hedge to be reclassified to interest expense, from other comprehensive income, in the next twelve months.

Derivative Loan Commitments

Mortgage loan commitments qualify as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding. The Company enters into commitments to fund residential mortgage loans at specified times in the future, with the intention that these loans will subsequently be sold in the secondary market. A mortgage loan commitment binds the Company to lend funds to a potential borrower at a specified interest rate and within a specified period of time, generally up to 60 days after inception of the rate lock.

Outstanding derivative loan commitments expose the Company to the risk that the price of the loans arising from exercise of the loan commitment might decline from inception of a rate lock to funding of the loan due to increases in mortgage interest rates. If interest rates increase, the value of these loan commitments decreases. Conversely, if interest rates decrease, the value of these loan commitments increases.

Forward Loan Sale Commitments

The Company utilizes both “mandatory delivery” and “best efforts” forward loan sale commitments to mitigate the risk of potential decreases in the values of loans that would result from the exercise of the derivative loan commitments.

With a “mandatory delivery” contract, the Company commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the Company fails to deliver the number of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a “pair-off” fee, based on then-current market prices, to the investor to compensate the investor for the shortfall.

With a “best efforts” contract, the Company commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, the price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower).

The Company expects that these forward loan sale commitments will experience changes in fair value opposite to the change in fair value of derivative loan commitments.

Interest Rate Swaps

The Company enters into interest rate swap agreements that are transacted to meet the financing needs of its commercial customers. Offsetting interest rate swap agreements are simultaneously transacted with a third-party financial institution to effectively eliminate the Company’s interest rate risk associated with the customer swaps. The primary risks associated with these transactions arise from exposure to the ability of the counterparties to meet the terms of the contract. At September 30, 2022, there were no securities pledged to secure the Company’s liability for the offsetting interest rate swaps (see Note 2). The interest rate swap notional amount is the aggregate notional amount of the customer swap and the offsetting third-party swap. The Company also assesses the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and determines whether the credit valuation adjustments are significant to the overall valuation of its derivatives. During 2021, a credit valuation adjustment related to an interest rate swap was determined to be significant and required a negative fair value adjustment of $430,000, which was included in other income. During the first quarter of 2022, the interest rate swap was terminated, which resulted in a reversal of $329,000 to the negative fair value adjustment recorded in 2021 to a negative fair value adjustment of $101,000 at March 31, 2022.

Risk Participation Agreements

The Company has entered into risk participation agreements with correspondent institutions and shares in any interest rate swap losses incurred as a result of the commercial loan customers’ termination of a loan-level interest rate swap agreement prior to maturity. The Company records these risk participation agreements at fair value. The Company’s maximum credit exposure is based on its proportionate share of the settlement amount of the referenced interest rate swap. Settlement amounts are generally calculated based on the fair value of the swap plus outstanding accrued interest receivables from the customer.

The following tables presents the outstanding notional balances and fair values of outstanding derivative instruments:

			Assets			Liabilities
			Balance			Balance
	Notional		Sheet	Fair		Sheet	Fair
	Amount		Location	Value		Location	Value
		(in thousands)
September 30, 2022:
Derivatives designated as Hedging Instruments
Interest rate swaps	$	100,000	Other assets	$	8,669	Other liabilities	$	—
Derivatives not designated as Hedging Instruments
Derivative loan commitments	$	47,154	Other assets	$	901	Other liabilities	$	343
Forward loan sale commitments		42,606	Other assets		1,334	Other liabilities		16
Interest rate swaps		657,517	Other assets		29,243	Other liabilities		29,243
Risk participation agreements		130,875	Other assets		—	Other liabilities		—
Total				$	40,147		$	29,602
December 31, 2021:
Derivatives designated as Hedging Instruments
Interest rate swaps	$	100,000	Other assets	$	1,663	Other liabilities	$	—
Derivatives not designated as Hedging Instruments
Derivative loan commitments	$	86,134	Other assets	$	1,527	Other liabilities	$	95
Forward loan sale commitments		96,000	Other assets		56	Other liabilities		94
Interest rate swaps		740,235	Other assets		18,874	Other liabilities		19,214
Risk participation agreements		139,109	Other assets		—	Other liabilities		—
Total				$	22,120		$	19,403

The following table presents the recorded net gains and losses pertaining to the Company’s derivative instruments:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2022		2021		2022		2021
	(in thousands)
Derivatives designated as hedging instruments
(Loss) gain in OCI on derivatives (effective portion), net of tax	$	1,610	$	116	$	5,038	$	1,271
(Loss) gain reclassified from OCI into interest income or interest expense (effective portion)	$	420	$	(140)	$	380	$	(373)
Derivatives not designated as hedging instruments
Changes in fair value of derivative loan commitments
Mortgage banking income	$	(606)	$	(1,897)	$	(874)	$	(9,178)
Changes in fair value of forward loan sale commitments
Mortgage banking income		1,377		1,064		1,356		3,059
Changes in fair value of interest rate swaps
Other income		—		—		330		—
Total	$	771	$	(833)	$	812	$	(6,119)