FAIR VALUE

Fair Value Measurement

Fair value is defined 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. To measure fair value, a hierarchy has been established that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:

Level 1 – Quoted prices in active markets for identical assets or liabilities in active markets that the Bank has the ability to access;

Level 2 – Observable inputs other than Level 1 including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in less active markets, observable inputs other than quoted prices that are used in the valuation of an asset or liability, and inputs that are derived principally from or corroborated by observable market data by correlation or other means; and

Level 3 – Unobservable inputs supported by little or no market activity for financial instruments whose value is determined by pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

The level in the fair value hierarchy within which the fair value measurement is classified is determined based on the lowest level input that is significant to the fair value measurement in its entirety. Market activity is presumed to be orderly in the absence of evidence of forced or disorderly sales, although such sales may still be indicative of fair value. Applicable accounting guidance precludes the use of blockage factors or liquidity adjustments due to the quantity of securities held by an entity.

We use fair value to measure certain assets and liabilities on a recurring basis when fair value is the primary measure for accounting. Fair value is used on a nonrecurring basis to measure certain assets when adjusting carrying values, such as the application of lower of cost or fair value accounting, including recognition of impairment on assets. Fair value is also used when providing required disclosures for certain financial instruments.

Fair Value Policies and Procedures

We have various policies, processes and controls in place to ensure that fair values are reasonably developed, reviewed and approved for use. These include a Securities Valuation Committee, comprised of executive management, that reviews and approves on a quarterly basis the key components of fair value estimation, including critical valuation assumptions for Level 3 modeling. A Model Risk Management Group conducts model validations, including internal models, and sets policies and procedures for revalidation, including the timing of revalidation.

Third Party Service Providers

We use a third party pricing service to measure fair value for approximately 95% of our AFS Level 2 securities. Fair value measurements for other AFS Level 2 securities generally use certain inputs corroborated by market data and include standard discounted cash flow analysis.

For Level 2 securities, the third party pricing service provides documentation on an ongoing basis that presents market corroborative data, including detail pricing information and market reference data. The documentation includes benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data, including information from the vendor trading platform. We review, test and validate this information as appropriate. Absent observable trade data, we do not adjust prices from our third party sources.

The following describes the hierarchy designations, valuation methodologies, and key inputs to measure fair value on a recurring basis for designated financial instruments:

Available-for-Sale

U.S. Treasury, Agencies and Corporations

U.S. Treasury securities are measured under Level 1 using quoted market prices when available. U.S. agencies and corporations are measured under Level 2 generally using the previously discussed third party pricing service.

Municipal Securities

Municipal securities are measured under Level 2 using the third party pricing service.

Money Market Mutual Funds and Other

Money market mutual funds and other securities are measured under Level 1 or Level 2. For Level 1, quoted market prices are used which may include net asset values (“NAVs”) or their equivalents. Level 2 valuations generally use quoted prices for similar securities. With the adoption of ASU 2016-01, as of January 1, 2018 our money market mutual funds are no longer classified as AFS and are now recognized in trading.

Trading Account

Securities in the trading account are generally measured under Level 2 using third party pricing service providers as described previously.

Held-to-Maturity

HTM securities are carried at amortized cost, but for disclosure purposes are measured at fair value using a third party pricing service or an internal model. The internal model utilizes observable market yields as inputs.

Bank-Owned Life Insurance

Bank-owned life insurance (“BOLI”) is measured under Level 2 according to CSVs of the insurance policies that are provided by a third party service. Nearly all policies are general account policies with CSVs based on the Bank’s claims on the assets of the insurance companies. The insurance companies’ investments include predominantly fixed income securities consisting of investment-grade corporate bonds and various types of mortgage instruments. Management regularly reviews its BOLI investment performance, including concentrations among insurance providers.

Private Equity Investments

PEIs are generally measured under Level 3. The majority of these PEIs are held in the Bank’s Small Business Investment Company (“SBIC”) and are early-stage venture investments. The fair value measurements of these investments are reviewed at least on a quarterly basis, including whenever a new round of financing occurs. Certain of these investments may be measured using multiples of operating performance. The fair value measurements of PEIs are reviewed on a quarterly basis by the Securities Valuation Committee. The Equity Investments Committee, consisting of executives familiar with the investments, reviews periodic financial information, including audited financial statements when available.

Certain valuation analytics may be employed that include current and projected financial performance, recent financing activities, economic and market conditions, market comparables, market liquidity, sales restrictions, and other factors. A significant change in the expected performance of the individual investment would result in a change in the fair value measurement of the investment. The amount of unfunded commitments to invest is disclosed in Note 15. Certain restrictions apply for the redemption of these investments and certain investments are prohibited by the Volcker Rule. See discussions in Notes 5 and 15.

Agriculture Loan Servicing

This asset results from our servicing of agriculture loans approved and funded by Federal Agricultural Mortgage Corporation (“FAMC”). We provide this servicing under an agreement with FAMC for loans they own. The asset’s fair value represents our projection of the present value of future cash flows measured under Level 3 using discounted cash flow methodologies.

Interest-Only Strips

Interest-only strips are created as a by-product of the securitization process. When the guaranteed portions of Small Business Administration (“SBA”) 7(a) loans are pooled, interest-only strips may be created in the pooling process. The asset’s fair value represents our projection of the present value of future cash flows measured under Level 3 using discounted cash flow methodologies.

Deferred Compensation Plan Assets and Obligations

Invested assets in the deferred compensation plan consist of shares of registered investment companies. These mutual funds are valued under Level 1 at quoted market prices, which represents the NAV of shares held by the plan at the end of the period.

Derivatives

Derivatives are measured according to their classification as either exchange-traded or over-the-counter. Exchange-traded derivatives consist of foreign currency exchange contracts measured under Level 1 because they are traded in active markets. Over-the-counter derivatives, including those for customers, consist of interest rate swaps and options. These derivatives are measured under Level 2 using third party services. Observable market inputs include yield curves (the London Interbank Offered Rate (“LIBOR”) swap curve and relevant overnight index swap curves), foreign exchange rates, commodity prices, option volatilities, counterparty credit risk, and other related data. Credit valuation adjustments are required to reflect nonperformance risk for both the Bank and the respective counterparty. These adjustments are determined generally by applying a credit spread to the total expected exposure of the derivative.

Securities Sold, Not Yet Purchased

Securities sold, not yet purchased, included in “Federal funds and other short-term borrowings” on the balance sheet, are measured under Level 1 using quoted market prices. If not available, quoted prices under Level 2 for similar securities are used.

Loans

Loans are generally carried at amortized cost, but for disclosure purposes are measured at fair value according to their status as nonimpaired or impaired. For nonimpaired loans, fair value is estimated by discounting future cash flows using the LIBOR yield curve adjusted by a factor which reflects the credit, interest rate risk, and liquidity inherent in the loan. These future cash flows are then reduced by the estimated “life-of-the-loan” aggregate credit losses in the loan portfolio. These adjustments for lifetime future credit losses are derived from the methods used to estimate the ALLL for our loan portfolio and are adjusted quarterly as necessary to reflect the most recent loss experience. Impaired loans that are collateral-dependent are already considered to be held at fair value. Impaired loans that are not collateral-dependent have future cash flows reduced by the estimated “life-of-the-loan” credit loss derived from methods used to estimate the ALLL for these loans. See Impaired Loans in Note 6 for details on the impairment measurement method for impaired loans. Loans, other than those held for sale, are not normally purchased and sold by the Bank, and there are no active trading markets for most of this portfolio.

Quantitative Disclosure by Fair Value Hierarchy

Assets and liabilities measured at fair value by class on a recurring basis are summarized as follows:



(In millions)	December 31, 2018
	Level 1		Level 2		Level 3		Total
ASSETS
Investment securities:
Available-for-sale:
U.S. Treasury, agencies and corporations	$	40	$	13,385	$	—	$	13,425
Municipal securities			1,291				1,291
Other debt securities			21				21
Total Available-for-sale	40		14,697		—		14,737
Trading account	14		92				106
Other noninterest-bearing investments:
Bank-owned life insurance			516				516
Private equity investments					102		102
Other assets:
Agriculture loan servicing and interest-only strips					18		18
Deferred compensation plan assets	95						95
Derivatives:
Interest rate related and other			1				1
Interest rate swaps for customers			40				40
Foreign currency exchange contracts	4						4
Total Assets	$	153	$	15,346	$	120	$	15,619
LIABILITIES
Securities sold, not yet purchased	$	85	$	—	$	—	$	85
Other liabilities:
Deferred compensation plan obligations	95						95
Derivatives:
Interest rate related and other			1				1
Interest rate swaps for customers			36				36
Foreign currency exchange contracts	2						2
Total Liabilities	$	182	$	37	$	—	$	219



(In millions)	December 31, 2017
	Level 1		Level 2		Level 3		Total
ASSETS
Investment securities:
Available-for-sale:
U.S. Treasury, agencies and corporations	$	25	$	13,706	$	—	$	13,731
Municipal securities			1,334				1,334
Other debt securities			24				24
Money market mutual funds and other	71		1				72
Total Available-for-sale	96		15,065		—		15,161
Trading account			148				148
Other noninterest-bearing investments:
Bank-owned life insurance			507				507
Private equity investments					95		95
Other assets:
Agriculture loan servicing and interest-only strips					18		18
Deferred compensation plan assets	102						102
Derivatives:
Interest rate related and other			1				1
Interest rate swaps for customers			28				28
Foreign currency exchange contracts	9						9
Total Assets	$	207	$	15,749	$	113	$	16,069
LIABILITIES
Securities sold, not yet purchased	$	95	$	—	$	—	$	95
Other liabilities:
Deferred compensation plan obligations	102						102
Derivatives:
Interest rate swaps for customers			33				33
Foreign currency exchange contracts	7						7
Total Liabilities	$	204	$	33	$	—	$	237

Reconciliation of Level 3 Fair Value Measurements

The following reconciles the beginning and ending balances of assets and liabilities that are measured at fair value by class on a recurring basis using Level 3 inputs:



	Level 3 Instruments
	December 31, 2018						December 31, 2017
(In millions)	Private equity investments			Ag loan svcg and int-only strips			Private equity investments			Ag loan svcg and int-only strips

Balance at beginning of year	$	95		$	18		$	73		$	20
Securities gains, net	2			—			7			—
Other noninterest income	—			1			—			(1		)
Purchases	11			—			20			—
Redemptions and paydowns	(6		)	(1		)	(5		)	(1		)
Balance at end of year	$	102		$	18		$	95		$	18

No transfers of assets or liabilities occurred among Levels 1, 2 or 3 for 2018 and 2017.

The reconciliation of Level 3 instruments includes the following realized gains and losses in the statement of income:



(In millions)	Year Ended December 31,
(In millions)	2018			2017

Securities gains (losses), net	$	(1	)	$	3

Nonrecurring Fair Value Measurements

Included in the balance sheet amounts are the following amounts of assets that had fair value changes measured on a nonrecurring basis:



(In millions)	Fair value at December 31, 2018								Gains (losses) from fair value changes Year Ended December 31, 2018
(In millions)	Level 1		Level 2		Level 3		Total
ASSETS
Private equity investments, carried at cost	$	—	$	—	$	1	$	1	$	—
Impaired loans	—		32		—		32		(13		)
Other real estate owned	—		—		—		—		(1		)
Total	$	—	$	32	$	1	$	33	$	(14	)



(In millions)	Fair value at December 31, 2017								Gains (losses) from fair value changes Year Ended December 31, 2017
(In millions)	Level 1		Level 2		Level 3		Total
ASSETS
Private equity investments, carried at cost	$	—	$	—	$	1	$	1	$	(1	)
Impaired loans	—		9		—		9		(5		)
Other real estate owned	—		—		—		—		—
Total	$	—	$	9	$	1	$	10	$	(6	)

The previous fair values may not be current as of the dates indicated, but rather as of the date the fair value change occurred, such as a charge for impairment. Accordingly, carrying values may not equal current fair value.

We recognized net gains of $1 million in 2018 and $2 million in 2017 from the sale of OREO properties that had a carrying value at the time of sale of approximately $4 million in 2018 and $6 million in 2017. Previous to their sale in these years, we recognized an insignificant amount of impairment on these properties in 2018 and 2017.

PEIs carried at cost were measured at fair value for impairment purposes according to the methodology previously discussed for these investments. Amounts of PEIs carried at cost were $10 million at both December 31, 2018 and 2017. Amounts of other noninterest-bearing investments carried at cost were $329 million and $338 million at December 31, 2018 and 2017, respectively, which were comprised of Federal Reserve and Federal Home Loan Bank (“FHLB”) stock. PEIs accounted for using the equity method were $35 million and $36 million at December 31, 2018 and 2017, respectively.

Impaired (or nonperforming) loans that are collateral-dependent were measured at fair value based on the fair value of the collateral. OREO was measured initially at fair value based on collateral appraisals at the time of transfer and subsequently at the lower of cost or fair value.

Measurement of fair value for collateral-dependent loans and OREO was based on third party appraisals that utilize one or more valuation techniques (income, market and/or cost approaches). Any adjustments to calculated fair value were made based on recently completed and validated third party appraisals, third party appraisal services, automated valuation services, or our informed judgment. Evaluations were made to determine that the appraisal process met the relevant concepts and requirements of applicable accounting guidance.

Automated valuation services may be used primarily for residential properties when values from any of the previous methods were not available within 90 days of the balance sheet date. These services use models based on market, economic, and demographic values. The use of these models has only occurred in a very few instances and the related property valuations have not been sufficiently significant to consider disclosure under Level 3 rather than Level 2.

Impaired loans that are not collateral-dependent were measured based on the present value of future cash flows discounted at the expected coupon rates over the lives of the loans. Because the loans were not discounted at market interest rates, the valuations do not represent fair value and have been excluded from the nonrecurring fair value balance in the preceding schedules.

Fair Value of Certain Financial Instruments

Following is a summary of the carrying values and estimated fair values of certain financial instruments:



	December 31, 2018					December 31, 2017
(In millions)	Carrying value		Estimated fair value		Level	Carrying value		Estimated fair value		Level
Financial assets:
Held-to-maturity investment securities	$	774	$	767	2	$	770	$	762	2
Loans and leases (including loans held for sale), net of allowance	46,312		45,251		3	44,306		44,226		3
Financial liabilities:
Time deposits	4,336		4,319		2	3,115		3,099		2
Long-term debt	724		727		2	383		402		2

This summary excludes financial assets and liabilities for which carrying value approximates fair value and financial instruments that are recorded at fair value on a recurring basis. Financial instruments for which carrying values approximate fair value include cash and due from banks, money market investments, demand, savings and money market deposits, federal funds purchased and other short-term borrowings, and security repurchase agreements. The estimated fair value of demand, savings and money market deposits is the amount payable on demand at the reporting date. Carrying value is used because the accounts have no stated maturity and the customer has the ability to withdraw funds immediately. Time and foreign deposits, and any other short-term borrowings, are measured at fair value by discounting future cash flows using the LIBOR yield curve to the given maturity dates. Long-term debt is measured at fair value based on actual market trades (i.e., an asset value) when available, or discounting cash flows to maturity using the LIBOR yield curve adjusted for credit spreads. The methods used to measure fair value for HTM securities and loans were previously described in this footnote.

These fair value disclosures represent our best estimates based on relevant market information and information about the financial instruments. Fair value estimates are based on judgments regarding current economic conditions, future expected loss experience, risk characteristics of the various instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of significant judgment, and cannot be determined with precision. Changes in these methodologies and assumptions could significantly affect the estimates.