19 – FAIR VALUE

Fair Value Option

FASB authoritative guidance permits the measurement of selected eligible financial instruments at fair value.

Medium-Term Notes

The Corporation elected the fair value option for certain medium term notes that were hedged with interest rate swaps that were previously designated for fair value hedge accounting. These medium-term notes were repaid during the second quarter of 2012. As of December 31, 2011, these medium-term notes with a principal balance of $15.4 million, had a fair value of $16.0 million, recorded in notes payable. Interest paid/accrued on these instruments was recorded as part of interest expense and the accrued interest was part of the fair value of the notes. Electing the fair value option allows the Corporation to eliminate the burden of complying with the requirements for hedge accounting (e.g., documentation and effectiveness assessment) without introducing earnings volatility.

Medium-term notes for which the Corporation elected the fair value option were priced using observable market data in the institutional markets.

Fair Value Measurement

The FASB authoritative guidance for fair value measurement defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs may be used to measure fair value:

Level 1

Valuations of Level 1 assets and liabilities are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. Level 1 assets and liabilities include equity securities that are traded in an active exchange market, as well as certain U.S. Treasury and other U.S. government and agency securities and corporate debt securities that are traded by dealers or brokers in active markets.

Level 2

Valuations of Level 2 assets and liabilities are based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include (i) mortgage-backed securities for which the fair value is estimated based on the value of identical or comparable assets, (ii) debt securities with quoted prices that are traded less frequently than exchange-traded instruments and (iii) derivative contracts and financial liabilities (e.g., medium-term notes elected to be measured at fair value) whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3

Valuations of Level 3 assets and liabilities are based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models for which the determination of fair value requires significant management judgment or estimation.

For 2012, there have been no transfers into or out of Level 1, Level 2 or Level 3 measurement of the fair value hierarchy.

Financial instruments Recorded at Fair Value on a Recurring Basis

Investment securities available for sale

The fair value of investment securities was the market value based on quoted market prices (as is the case with equity securities, U.S. Treasury notes and non-callable U.S. Agency debt securities), when available (Level 1), or market prices for identical or comparable assets (as is the case with MBS and callable U.S. agency debt) that are based on observable market parameters including benchmark yields, reported trades, quotes from brokers or dealers, issuer spreads, bids, offers and reference data including market research operations, (Level 2). Observable prices in the market already consider the risk of nonperformance. If listed prices or quotes are not available, fair value is based upon models that use unobservable inputs due to the limited market activity of the instrument, as is the case with certain private label mortgage-backed securities held by the Corporation, (Level 3).

Private label MBS are collateralized by fixed-rate mortgages on single-family residential properties in the United States; the interest rate on the securities is variable, tied to 3-month LIBOR and limited to the weighted-average coupon of the underlying collateral. The market valuation represents the estimated net cash flows over the projected life of the pool of underlying assets applying a discount rate that reflects market observed floating spreads over LIBOR, with a widening spread bias on a nonrated security. The market valuation is derived from a model that utilizes relevant assumptions such as prepayment rate, default rate, and loss severity on a loan level basis. The Corporation modeled the cash flow from the fixed-rate mortgage collateral using a static cash flow analysis according to collateral attributes of the underlying mortgage pool (i.e. loan term, current balance, note rate, rate adjustment type, rate adjustment frequency, rate caps, others) in combination with prepayment forecasts obtained from a commercially available prepayment model (ADCO). The variable cash flow of the security is modeled using the 3-month LIBOR forward curve. Loss assumptions were driven by the combination of default and loss severity estimates, taking into account loan credit characteristics (loan-to-value, state, origination date, property type, occupancy loan purpose, documentation type, debt-to-income ratio, other) to provide an estimate of default and loss severity.

Corporate bonds are collateralized by an agency zero-coupon bond and a synthetic Collateralized Debt Obligation of 125 corporate bonds rated investment grade at the time of structuring. The value of the bonds is tied to the level of credit default swap spreads.

Refer to table below for further information regarding qualitative information for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3).

Derivative instruments

The fair value of most of the derivative instruments is based on observable market parameters and takes into consideration the credit risk component of paying counterparties when appropriate, except when collateral is pledged. That is, on interest rate swaps, the credit risk of both counterparties is included in the valuation; and, on options and caps, only the seller’s credit risk is considered. The derivative instruments, namely swaps and caps, were valued using a discounted cash flow approach using the related US LIBOR and swap rate for each cash flow. Derivatives include interest rate swaps used for protection against rising interest rates. For these interest rate swaps, a credit component was not considered in the valuation since the Corporation has fully collateralized with investment securities any mark to market loss with the counterparty and, if there were market gains, the counterparty had to deliver collateral to the Corporation.

Although most of the derivative instruments are fully collateralized, a credit spread is considered for those that are not secured in full. The cumulative mark-to-market effect of credit risk in the valuation of derivative instruments for the quarter and nine-month period ended September 30, 2012 was immaterial.

Term notes payable

The fair value of term notes was determined using a discounted cash flow analysis over the full term of the borrowings. The model assumes that the embedded options are exercised economically. The discount rates used in the valuations consider 3-month LIBOR forward curves and the credit spread at every cash flow. During the second quarter of 2012, the Corporation prepaid medium term notes with a principal balance of $15.4 million that carried a rate of 6.00%. These notes were carried at fair value and changes in value were recorded as part of interest expense. As a result of the prepayment of the notes, a marked-to-market loss of $0.5 million was reversed resulting in a reduction in interest expense for the nine-month period ended on September 30, 2012.

Assets and liabilities measured at fair value on a recurring basis, including financial liabilities for which the Corporation has elected the fair value option, are summarized below:


	As of September 30, 2012								As of December 31, 2011
	Fair Value Measurements Using								Fair Value Measurements Using
(In thousands)	Level 1		Level 2		Level 3		Assets/Liabilities at Fair Value		Level 1		Level 2		Level 3		Assets/Liabilities at Fair Value
Assets:
Securities available for sale :
Equity securities	$	40	$	—	$	—	$	40	$	41	$	—	$	—	$	41
U.S. Treasury Securities		7,495		—		—		7,495		476,992		—		—		476,992
Non-callable U.S. agency debt		—		—		—		—		301,585		—		—		301,585
Callable U.S. agency debt and MBS		—		1,472,277		—		1,472,277		—		859,818		—		859,818
Puerto Rico Government Obligations		—		59,603		3,743		63,346		—		219,369		3,244		222,613
Private label MBS		—		—		54,689		54,689		—		—		61,206		61,206
Corporate bonds		—		—		—		—		—		—		1,013		1,013
Derivatives, included in assets:
Interest rate swap agreements		—		318		—		318		—		378		—		378
Purchased options used to manage exposure to the stock market on embeded stock indexed options		—		—		—		—		—		899		—		899
Forward contracts		—		18		—		18		—		—		—		—
Liabilities:
Medium-term notes		—		—		—		—		—		15,968		—		15,968
Derivatives, included in liabilities:
Interest rate swap agreements		—		6,238		—		6,238		—		6,767		—		6,767
Embedded written options on stock index deposits and notes payable		—		—		—		—		—		899		—		899
Forward Contracts		—		190		—		190		—		168		—		168

Total	$	7,535	$	1,538,644	$	58,432	$	1,604,611	$	778,618	$	1,104,266	$	65,463	$	1,948,347


	Changes in Fair Value for items Measured at Fair Value Pursuant to Election of the Fair Value Option For the Quarter ended September 30,
	2012		2011
(In thousands)	Decrease (increase) in Interest Expense included in Current-Period Earnings ⁽¹⁾
Medium-term notes	$	—	$	(1,871	)

(1)

Changes in fair value for the quarter ended September 30, 2011 include interest expense on medium-term notes of $0.2 million. Interest expense on medium-term notes that have been elected to be carried at fair value are recorded in interest expense in the Consolidated Statement of Income (Loss) based on their contractual coupons.


	Changes in Fair Value for items Measured at Fair Value Pursuant to Election of the Fair Value Option For the Nine-Month Period Ended September 30,
	2012			2011
(In thousands)	Decrease (increase) in Interest Expense included in Current-Period Earnings ⁽¹⁾
Medium-term notes	$	(140	)	$	(2,864	)

(1)

Changes in fair value for the nine-month period ended September 30, 2012 and 2011 include interest expense on medium-term notes of $0.4 million and $0.7 million, respectively. Interest expense on medium-term notes that have been elected to be carried at fair value are recorded in interest expense in the Consolidated Statement of Income (Loss) based on their contractual coupons.

The table below presents a reconciliation for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarter and nine-month period ended September 30, 2012 and 2011.


	Total Fair Value Measurements Quarter ended September 30,
	2012			2011
Level 3 Instruments Only (In thousands)	Securities Available For Sale⁽¹⁾			Securities Available For Sale⁽¹⁾
Beginning balance	$	61,838			71,412
Total gains or (losses) (realized/unrealized):
Included in earnings		(557	)		(350	)
Included in other comprehensive income		1,666			897
Sales		(1,450	)		—
Principal repayments and amortization		(3,065	)		(3,851	)

Ending balance	$	58,432		$	68,108

(1)	Amounts mostly related to private label mortgage-backed securities.


	Total Fair Value Measurements Nine-Month Period Ended September 30,
	2012			2011
Level 3 Instruments Only (In thousands)	Securities Available For Sale⁽¹⁾			Securities Available For Sale⁽¹⁾
Beginning balance	$	65,463			74,993
Total gains or (losses) (realized/unrealized):
Included in earnings		(1,933	)		(957	)
Included in other comprehensive income		6,722			2,768
Held-to-Maturity investment securities reclassified to Available-for-Sale		—			2,000
Sales		(1,450	)		—
Principal repayments and amortization		(10,370	)		(10,696	)

Ending balance	$	58,432		$	68,108

(1)	Amounts mostly related to private label mortgage-backed securities.

The table below presents qualitative information for all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at September 30, 2012.


	September 30, 2012
(In thousands)	Fair Value		Valuation Technique	Unobservable Input	Range
Investment securities available-for-sale:
Private label MBS	$	54,689	Discounted cash flow	Discount rate	14.5%
				Prepayment rate	23.81% - 43.58% (Weighted Average 33%)
				Projected Cumulative Loss Rate	0.71% - 17.51% (Weighted Average 7%)
Puerto Rico Government Obligations		3,743	Discounted cash flow	Prepayment Speed	5.95%

Information about Sensitivity to Changes in Significant Unobservable Inputs

Private label MBS: The significant unobservable inputs in the valuation include probability of default, the loss severity assumption and the prepayment rates. Shifts in those inputs would result in different fair value measurements. Increases in the probability of default, loss severity assumptions and pre-payments rates in isolation would generally result in an adverse effect in the fair value of the instruments. Meaningful and possible shifts of each input were modeled to assess the effect on the fair value estimation.

Puerto Rico Government Obligations: The significant unobservable input used in the fair value measurement is the assumed prepayment speed. A significant increase (decrease) in the assumed speed would lead to a higher (lower) fair value estimate. Loss severity and probability of default are not included as significant unobservable variables because the note is guaranteed by the Puerto Rico Housing Finance Authority (“PRHFA”). The PRHFA credit risk is modeled by discounting the cash flows using a curve appropriate to the PRHFA credit rating.

Additionally, fair value is used on a non-recurring basis to evaluate certain assets in accordance with GAAP. Adjustments to fair value usually result from the application of lower-of-cost-or-market accounting (e.g., loans held for sale carried at the lower of cost or fair value and repossessed assets) or write-downs of individual assets (e.g., goodwill, loans).

As of September 30, 2012, impairment or valuation adjustments were recorded for assets recognized at fair value on a non-recurring basis as shown in the following table:


	Carrying value as of September 30, 2012						Losses recorded for the Quarter Ended September 30, 2012		Losses recorded for the Nine-Month Period Ended September 30, 2012
	Level 1		Level 2		Level 3
	(In thousands)
Loans receivable ⁽¹⁾	$	—	$	—	$	702,308	$	19,676	$	80,172
Other Real Estate Owned ⁽²⁾		—		—		177,001		3,264		7,860
Mortgage servicing rights ⁽³⁾		—		—		16,660		363		203

(1)

Mainly impaired commercial and construction loans. The impairment was generally measured based on the fair value of the collateral. The fair values are derived from external appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the collateral (e.g. absorption rates), which are not market observable.

(2)

The fair value is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the properties (e.g. absorption rates), which are not market observable. Losses are related to market valuation adjustments after the transfer from the loan to the Other Real Estate Owned (“OREO”) portfolio.

(3)

Fair value adjustments to mortgage servicing rights were mainly due to assumptions associated with mortgage prepayment rates. The Corporation carries its mortgage servicing rights at lower of cost or market, and they are accordingly measured at fair value on a non-recurring basis. Assumptions for the value of mortgage servicing rights include: Prepayment rate 12.66%, Discount Rate 11.09%.

As of September 30, 2011, impairment or valuation adjustments were recorded for assets recognized at fair value on a non-recurring basis as shown in the following table:


	Carrying value as of September 30, 2011						Losses recorded for the Quarter Ended September 30, 2011		Losses recorded for the Nine-Month Period Ended September 30, 2011
	Level 1		Level 2		Level 3
	(In thousands)
Loans receivable ⁽¹⁾	$	—	$	—	$	842,773	$	45,312	$	187,269
Other Real Estate Owned ⁽²⁾		—		—		109,514		2,325		6,294

(1)

(2)

Qualitative information regarding the fair value measurements for Level 3 financial instruments are as follows:


	September 30, 2012
	Method	Inputs

Loans	Income, Market, Comparable Sales, Discounted Cash Flows	External appraised values; probability weighting of broker price opinions; management assumptions regarding market trends or other relevant factors
OREO	Income, Market, Comparable Sales, Discounted Cash Flows	External appraised values; probability weighting of broker price opinions; management assumptions regarding market trends or other relevant factors
Mortgage servicing rights	Discounted Cash Flow	Weighted average prepayment speed 12.66%; weighted average discount rate 11.09%

The following is a description of the valuation methodologies used for instruments that are not measured and reported at fair value on a recurring basis or non-recurring basis. The estimated fair value was calculated using certain facts and assumptions, which vary depending on the specific financial instrument.

Cash and due from banks and money market investments

The carrying amounts of cash and due from banks and money market investments are reasonable estimates of their fair value. Money market investments include held-to-maturity U.S. Government obligations, which have a contractual maturity of three months or less. The fair value of these securities is based on quoted market prices in active markets that incorporate the risk of nonperformance.

Other equity securities

Equity or other securities that do not have a readily available fair value are stated at the net realizable value, which management believes is a reasonable proxy for their fair value. This category is principally composed of stock that is owned by the Corporation to comply with FHLB regulatory requirements. Their realizable value equals their cost as these shares can be freely redeemed at par.

Loans receivable, including loans held for sale

The fair value of loans held for investment and for mortgage loans held for sale was estimated using discounted cash flow analyses, based on interest rates currently being offered for loans with similar terms and credit quality and with adjustments that the Corporation’s management believes a market participant would consider in determining fair value. Loans were classified by type such as commercial, residential mortgage, and automobile. These asset categories were further segmented into fixed- and adjustable-rate categories. The fair values of performing fixed-rate and adjustable-rate loans were calculated by discounting expected cash flows through the estimated maturity date. This fair value is not currently an indication of an exit price as that type of assumption could result in a different fair value estimate. The fair value of credit card loans was estimated using a discounted cash flow method and excludes any value related to customer account relationship. Loans with no stated maturity, like credit lines, were valued at book value. Prepayment assumptions were considered for non-residential loans. For residential mortgage loans, prepayment estimates were based on recent historical prepayment experience of the Corporation’s residential mortgage portfolio. Discount rates were based on the Treasury and LIBOR/Swap Yield Curves at the date of the analysis, and included appropriate adjustments for expected credit losses and liquidity.

Deposits

The estimated fair value of demand deposits and savings accounts, which are deposits with no defined maturities, equals the amount payable on demand at the reporting date. The fair values of retail fixed-rate time deposits, with stated maturities, are based on the present value of the future cash flows expected to be paid on the deposits. The cash flows were based on contractual maturities; no early repayments are assumed. Discount rates were based on the LIBOR yield curve.

The estimated fair value of total deposits excludes the fair value of core deposit intangibles, which represent the value of the customer relationship measured by the value of demand deposits and savings deposits that bear a low or zero rate of interest and do not fluctuate in response to changes in interest rates.

The fair value of brokered CDs, which are included within deposits, is determined using discounted cash flow analyses over the full term of the CDs. The fair value of the CDs is computed using the outstanding principal amount. The discount rates used are based on brokered CD market rates as of September 30, 2012. The fair value does not incorporate the risk of nonperformance, since interests in brokered CDs are generally sold by brokers in amounts of less than $250,000 and, therefore, insured by the FDIC.

Securities sold under agreements to repurchase

Some repurchase agreements reprice at least quarterly, and their outstanding balances are estimated to be their fair value. Where longer commitments are involved, fair value is estimated using exit price indications of the cost of unwinding the transactions as of the end of the reporting period. The brokers who are the counter-parties provide these indications. Securities sold under agreements to repurchase are fully collateralized by investment securities.

Advances from FHLB

The fair value of advances from FHLB with fixed maturities is determined using discounted cash flow analyses over the full term of the borrowings, using indications of the fair value of similar transactions. The cash flows assume no early repayment of the borrowings. Discount rates are based on the LIBOR yield curve. For advances from FHLB that reprice quarterly, their outstanding balances are estimated to be their fair value. Advances from FHLB are fully collateralized by mortgage loans and, to a lesser extent, investment securities.

Other borrowings

Other borrowings consist of junior subordinated debentures. Projected cash flows from the debentures were discounted using the LIBOR yield curve plus a credit spread. This credit spread was estimated using the difference in yield curves between Swap rates and a yield curve that considers the industry and credit rating of the Corporation as issuer of the note at a tenor comparable to the time to maturity of the debentures.

The following table presents the estimated fair value and carrying value of financial instruments as of September 30, 2012 and December 31, 2011


	Total Carrying Amount in Statement of Financial Condition September 30, 2012			Fair Value Estimated September 30, 2012		Level 1		Level 2		Level 3
	(In thousands)
Assets:
Cash and due from banks and money market investments	$	1,003,720		$	1,003,720	$	1,003,720	$	—	$	—
Investment securities available for sale		1,597,847			1,597,847		7,535		1,531,880		58,432
Other equity securities		39,656			39,656		—		39,656		—
Loans held for sale		68,349			70,976		—		70,976		—
Loans, held for investment		10,188,164			—		—		—		—
Less: allowance for loan and lease losses		(445,531	)

Loans held for investment, net of allowance	$	9,742,633			9,466,460		—		—		9,466,460

Derivatives, included in assets		336			336		—		336		—
Liabilities:
Deposits		9,896,402			9,937,355		—		9,937,355		—
Securities sold under agreements to repurchase		900,000			997,179		—		997,179		—
Advances from FHLB		518,440			524,176		—		524,176		—
Other borrowings		231,959			132,599		—		—		132,599
Derivatives, included in liabilities		6,428			6,428		—		6,428		—


	Total Carrying Amount in Statement of Financial Condition December 31, 2011			Fair Value Estimated December 31, 2011
	(In thousands)
Assets:
Cash and due from banks and money market investments	$	446,566		$	446,566
Investment securities available for sale		1,923,268			1,923,268
Other equity securities		37,951			37,951
Loans held for sale		15,822			16,038
Loans, held for investment		10,559,392			—
Less: allowance for loan and lease losses		(493,917	)		—

Loans held for investment, net of allowance	$	10,065,475			9,618,267

Derivatives, included in assets		1,277			1,277
Liabilities:
Deposits		9,907,754			9,974,119
Securities sold under agreements to repurchase		1,000,000			1,102,263
Advances from FHLB		367,440			379,730
Notes Payable		23,342			22,476
Other borrowings		231,959			160,603
Derivatives, included in liabilities		7,834			7,834