7. DERIVATIVES AND FINANCIAL INSTRUMENTS

9 Months Ended

Sep. 30, 2017

Derivatives And Financial Instruments

To mitigate exposure to variability in expected future cash flows resulting from changes in interest rates, in May 2013 the Company entered into two forward swap arrangements (the “Swaps”) whereby the Company would pay fixed rates on two short-term borrowings at some point in the future for a determined period of time. For both agreements, the Company would renew advances with the Federal Home Loan Bank (“FHLB”) for 3-month terms as a primary funding source and pay the prevailing 3-month rate. The first swap, a “2-5 Swap”, was a $20 million agreement whereby 2 years from the May 2013 execution date, the Company would begin to swap out the 3-month FHLB advance pricing at that date for a fixed rate of 1.964% for a period of 5 years. The second swap, a “3-5 Swap”, was similar in terms except that it was a $30 million agreement whereby 3 years from the May 2013 execution date, the Company would begin to swap out the 3-month FHLB advance pricing at that date for a fixed rate of 2.464% for a period of 5 years.

The Company designated the forward-starting interest rate swaps (the hedging instruments) as cash flow hedges of the risk of changes attributable to the benchmark 3-Month LIBOR interest rate risk for the forecasted issuances of FHLB advances arising from a rollover strategy. The Company intended to sequentially issue a series of 3-month fixed rate debt as part of a planned roll-over of short-term debt for the next seven to eight years.

In September 2014, as a result of continued increasing fixed rate exposure, the Company determined that an additional strategy was needed and, as a result, exited from the Swaps for a deferred gain of $372,000. In their place, the Company purchased three interest rate caps with a strike price of 3-month LIBOR at 0.50% and a five-year term. The instruments hedged were $100 million of FHLB borrowings maturing quarterly on the same reset dates. The Company executed three separate agreements between $30 million and $35 million maturing between August 2019 and October 2019.

The following table reflects the cash flow hedges included in the consolidated balance sheets as of September 30, 2017 and December 31, 2016:

	September 30, 2017				December 31, 2016
	Notional		Fair		Notional		Fair
(In thousands)	Amount		Value		Amount		Value
Included in other assets:
Cap 1 - maturing August 2019	$	35,000	$	794	$	35,000	$	1,011
Cap 2 - maturing September 2019		35,000		821		35,000		1,045
Cap 3 - maturing October 2019		30,000		737		30,000		929
	$	100,000	$	2,352	$	100,000	$	2,985

Remaining amortization of the premium on the interest rate caps is as follows:

(In thousands)
2017	$	508
2018		2,247
2019		1,752
	$	4,507

The Company recorded $474,000 and $257,000 for the three-month periods ended September 30, 2017 and 2016, respectively, in amortization associated with the interest rate caps. The Company recorded $1.3 million and $598,000 for the nine-month periods ended September 30, 2017 and 2016, respectively, in amortization associated with the interest rate caps. Those expenses are reflected in the consolidated statements of income as a component of borrowings and repurchase agreements interest expense.

Remaining amortization of the gain associated with the exit of the Swaps is as follows:

(In thousands)
2017		19
2018		74
Thereafter		147
	$	240

The Company realized $19,000 and $50,000 in gains on the Swaps during the three- and nine-month periods ended September 30, 2017, respectively, shown as a reduction of borrowings and repurchase agreements interest expense.

The Company anticipates little to no ineffectiveness in this hedging relationship as long as the terms are matched at each forecasted debt issuance. The Company notes that the actual interest cost incurred at each rollover will be a function of market rates at that time. However, the Company is only hedging the benchmark interest rate risk in each rollover.

The Company does not use derivatives for trading or speculative purposes.

Paragon Commercial CORP 10-Q