Derivative Financial Instruments

3 Months Ended

Mar. 31, 2017

Derivative Financial Instruments

Derivative Financial Instruments

Note 16 — Derivative Financial Instruments

Cash Flow Hedge of Interest Rate Risk

The Company utilizes an interest rate swap agreement to essentiallyconvert a portion of its variable-rate debt to a fixed rate (cash flow hedge).  For derivatives designated as hedging exposure to variable cash flows of a forecasted transaction (cash flow hedge), the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings or when the hedge is terminated. The ineffective portion of the gain or loss is reported in earnings immediately. For derivatives that are not designated as hedging instruments, changes in the fair value of the derivatives are recognized in earnings immediately.

When applying hedge accounting for derivatives, the Company establishes a method for assessing the effectiveness of the hedging derivative and a measurement approach for determining the ineffective aspect of the hedge upon the inception of the hedge.

During 2009, the Company entered into a forward starting interest rate swap agreement with a notional amount of $8.0 million to manage interest rate risk due to periodic rate resets on its junior subordinated debt issued by SCBT Capital Trust II, an unconsolidated subsidiary of the Company established for the purpose of issuing trust preferred securities.  The Company hedges the variable rate cash flows of subordinated debt against future interest rate increases by using an interest rate swap that effectively fixed the rate on the debt beginning on June 15, 2010, at which time the debt contractually converted from a fixed interest rate to a variable interest rate.  This hedge expires on June 15, 2019.  The notional amount on which the interest payments are based will not be exchanged.  This derivatives contract calls for the Company to pay a fixed rate of 4.06% on $8.0 million notional amount and receive a variable rate of three-month LIBOR on the $8.0 million notional amount.

The Company recognized an after-tax unrealized gain on its cash flow hedge in other comprehensive income of $44,000 for the three months ended March 31, 2017, compared to an unrealized loss of $49,000 for the three months ended March 31, 2016.  The Company recognized a $426,000 cash flow hedge liability in other liabilities on the balance sheet at March 31, 2017, compared to a $797,000 liability at March 31, 2016.  There was no ineffectiveness in the cash flow hedge during the three months ended March 31, 2017 and 2016.

On January 3, 2017, the Company, through its merger with Southeastern Banking Financial Corporation (“SBFC”), acquired two forward starting interest rate swaps with a total notational amount of $10.0 million which was used to manage interest rate risk by SBFC on its $20.6 million in junior subordinated debt issued by capital trusts.  Like the Company, SBFC was using the swaps to hedge the variable rate cash flows of subordinated debt against future interest rate increases by using an interest rate swap that effectively fixed the rate on the debt.  The subordinated debt was paying interest at three month LIBOR plus 1.40% (2.36% at the time of the merger) while the interest rate swaps were providing a fixed rate of approximately 5.35% on $10.0 million of the junior subordinated debt.  During the first quarter of 2017, the Company decided to terminate the interest rate swaps acquired through the merger with SBFC with an immaterial effect to net income.

Credit risk related to the derivative arises when amounts receivable from the counterparty (derivatives dealer) exceed those payable.  The Company controls the risk of loss by only transacting with derivatives dealers that are national market makers whose credit ratings are strong. Each party to the interest rate swap is required to provide collateral in the form of cash or securities to the counterparty when the counterparty’s exposure to a mark-to-market replacement value exceeds certain negotiated limits.  These limits are typically based on current credit ratings and vary with ratings changes.  As of March 31, 2017 and 2016, the Company provided $550,000 and $850,000 of collateral, which is included in cash and cash equivalents on the balance sheet as interest-bearing deposits with banks.  Also, the Company has a netting agreement with the counterparty.

Non-designated Hedges of Interest Rate Risk

Customer Swap

On December 28, 2016, the Company entered into two interest rate swap contracts that were classified as non-designated hedges and are not speculative in nature. One of the derivatives is an interest rate swap that was executed with a commercial borrower to facilitate a respective risk management strategy and allow the customer to pay a fixed rate of interest to the Company.  This interest rate swap was simultaneously hedged by executing an offsetting interest rate swap that was entered into with a derivatives dealer to minimize the net risk exposure to the Company resulting from the transactions and allow the Company to receive a variable rate of interest.

As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.  As of March 31, 2017, the interest rate swaps had an aggregate notional amount of approximately $27.5 million and the fair value of these two interest rate swap derivatives are recorded in other assets and in other liabilities for a net asset carrying value of $12,000, which was recorded through earnings.

Mortgage Banking

The Company also has derivatives contracts that are classified as non-designated hedges.  These derivatives contracts are a part of the Company’s risk management strategy for its mortgage banking activities.  These instruments may include financial forwards, futures contracts, and options written and purchased, which are used to hedge mortgage servicing rights; while forward sales commitments are typically used to hedge the mortgage pipeline.  Such instruments derive their cash flows, and therefore their values, by reference to an underlying instrument, index or referenced interest rate.  The Company does not elect hedge accounting treatment for any of these derivative instruments and as a result, changes in fair value of the instruments (both gains and losses) are recorded in the Company’s consolidated statements of income in mortgage banking income.

Mortgage Servicing Rights

Derivatives contracts related to mortgage servicing rights are used to help offset changes in fair value and are written in amounts referred to as notional amounts.  Notional amounts provide a basis for calculating payments between counterparties but do not represent amounts to be exchanged between the parties, and are not a measure of financial risk.  On March 31, 2017, the Company had derivative financial instruments outstanding with notional amounts totaling $98.0 million related to mortgage servicing rights, compared to $121.0 million on March 31, 2016.  The estimated net fair value of the open contracts related to the mortgage servicing rights was recorded as a gain of $214,000 at March 31, 2017, compared to a loss of $150,000 at March 31, 2016.

Mortgage Pipeline

The following table presents the Company’s notional value of forward sale commitments and the fair value of those obligations along with the fair value of the mortgage pipeline.

(Dollars in thousands)	March 31, 2017		December 31, 2016		March 31, 2016
Mortgage loan pipeline	$	117,666	$	85,445	$	115,945
Expected closures		88,250		64,083		86,959
Fair Value of mortgage loan pipeline commitments		2,066		1,037		2,187
Forward sales commitments		114,079		97,092		106,000
Fair value of forward commitments		(387)		1,366		(461)