CHFC 2018 Annual Report

Mortgage Banking Operations The Corporation generally sells conforming long-term fixed interest rate mortgage loans it originates in the secondary market. Gains on the sales of these loans are determined using the specific identification method. The Corporation sells residential mortgage loans in the secondary market primarily on a servicing retained basis. The Corporation elected the fair value measurement option, as prescribed by ASC Topic 820, Fair Value Measurements and Disclosures ("ASC 820"), for all residential mortgage loans held-for-sale originated on or after July 1, 2012. This election allows for a more effective offset of the changes in fair value of residential mortgage loans held-for-sale and the derivative instruments used to economically hedge themwithout having to apply complex hedge accounting provisions. Residential mortgage loans held-for-sale are carried at fair value, with changes in fair value recorded through earnings. Residential mortgage loan commitments, forward commitments, are generally entered into at the time interest-rate locks are accepted to protect the value of the mortgage loans from increases in market interest rates during the period held and are generally settled with the investor in the secondary market within 90 days after entering into the forward commitment. Forward loan commitments are accounted for as derivatives and recorded at fair value, with changes in fair value recorded through earnings. The Corporation recognizes revenue associated with the expected future cash flows of servicing loans for loans held-for-sale at the time a forward loan commitment ismade to originate a held-for-sale loan, as required under SECStaffAccounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value through Earnings. The Corporation purchases and originates loans for sale to the secondary market and sell the loans on either a servicing retained or servicing-released basis. If we retain the right to service the loan, a loan servicing right ("LSR") is created at the time of sale which is recorded at fair value. Effective January 1, 2017, the Corporation elected to account for all LSRs previously accounted for under the lower of cost or fair value method under the fair value method. Management believes this election will provide more comparable results to peers as many of those within our industry group account for loan servicing rights under the fair value method. The change in accounting policy in the first quarter of 2017 resulted in a cumulative adjustment to increase retained earnings in the amount of $3.7 million, net of taxes. LSRs are established and recorded at the estimated fair value by calculating the present fair value of estimated future net servicing cash flows. To determine the fair value of LSRs, the Corporation uses an independent third party valuationmodel requiring the incorporation of assumptions that market participants would use in estimating future net servicing income, which include estimates of prepayment speeds, discount rate, cost to service and escrow account earnings. Changes in the fair value of LSRs directly impact earnings. Servicing income is recognized in net gain on sale of loans and other mortgage banking revenue in the Consolidated Statements of Income when earned. Derivatives The Corporation enters into derivatives to manage the fair value changes, exposure to fluctuations exposed to price and interest rate risk, facilitate asset/liability management, minimize the variability of future cash flows on long-term debt, and to provide a service to certain qualifying customers to help facilitate their respective risk management strategies ("customer-initiated derivatives"). All derivatives are recognized on the Consolidated Statements of Financial Condition as other assets and liabilities, as applicable, at their estimated fair value. For derivatives designated as qualified cash flow hedges, changes in the fair value of the derivatives, to the extent effective as a hedge, are recorded in accumulated other comprehensive income, net of income taxes, and reclassified into earnings concurrently with the earnings of the hedged item. For customer-initiated and mortgage banking derivatives, changes in the fair value of the derivative are recognized immediately in earnings. Interest rate swaps are entered into in order to economically hedge the effect of changes and to mitigate the impact of fluctuations in interest rate volatility to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts. These derivatives are designated as cash flow hedges. The changes in fair value of derivatives designated and that qualify as cash flow hedges are recorded in accumulated other comprehensive income (loss) and are subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. For the Corporation's derivative instruments that are designated and qualify as a cash flow hedge, the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings in the same line item as the offsetting loss or gain on the related interest rate swap. The Corporation expects the hedges to remain highly effective during the remaining terms of the swaps. Interest rate swaps, are valued based on quoted prices for similar assets in an active market with inputs that are observable. Chemical Financial Corporation Notes to Consolidated Financial Statements December 31, 2018 94