Note 9. Fair Value of Financial Instruments

FASB ASC 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value in U.S. GAAP and expands disclosures about fair value measurements. The definition of fair value focuses on the exit price, i.e., the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not the entry price, i.e., the price that would be paid to acquire the asset or received to assume the liability at the measurement date. The statement emphasizes that fair value is a market-based measurement; not an entity-specific measurement. Therefore, the fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.

The following tables present financial instruments measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013, by caption on the consolidated balance sheets and by FASB ASC 820 valuation hierarchy (as described above) (in thousands):

September 30, 2014	Total carrying value in the consolidated balance sheet		Quoted market prices in an active market (Level 1)		Models with significant observable market parameters (Level 2)		Models with significant unobservable market parameters (Level 3)
Investment securities available-for-sale:
U.S. Treasury securities	$	-	$	-	$	-	$	-
U.S. government agency securities		111,098		-		111,098		-
Mortgage-backed securities		435,654		-		435,654		-
State and municipal securities		143,195		-		143,195		-
Agency-backed securities		13,766		-		13,766		-
Corporate notes and other		11,208		-		11,208		-
Total investment securities available-for-sale		714,921		-		714,921		-
Other equity investments		7,464		-		-		7,464
Other assets		15,463		-		15,463		-
Total assets at fair value	$	737,848	$	-	$	730,384	$	7,464

Other liabilities	$	12,668	$	-	$	12,668	$	-
Total liabilities at fair value	$	12,668	$	-	$	12,668	$	-

December 31, 2013
Investment securities available-for-sale:
U.S. government agency securities	$	103,873	$	-	$	103,873	$	-
Mortgage-backed securities		412,936		-		412,936		-
State and municipal securities		148,411		-		148,411		-
Agency-backed securities		17,007		-		17,007		-
Corporate notes and other		11,229		-		11,229		-
Total investment securities available-for-sale		693,456		-		693,456		-
Other equity investments		6,701		-		-		6,701
Other assets		19,900		-		19,900		-
Total assets at fair value	$	720,057	$	-	$	713,356	$	6,701

Other liabilities	$	13,670	$	-	$	13,670	$	-
Total liabilities at fair value	$	13,670	$	-	$	13,670	$	-

The following table presents assets measured at fair value on a nonrecurring basis as of September 30, 2014 and December 31, 2013 (in thousands):

September 30, 2014	Total carrying value in the consolidated balance sheet		Quoted market prices in an active market (Level 1)		Models with significant observable market parameters (Level 2)		Models with significant unobservable market parameters (Level 3)		Total losses for the year-to-date period then ended
Other real estate owned	$	12,329	$	-	$	-	$	12,329	$	(509	)
Nonaccrual loans, net ⁽¹⁾		20,427		-		-		20,427		(754	)
Total	$	32,756	$	-	$	-	$	32,756	$	(1,263	)

December 31, 2013
Other real estate owned	$	15,226	$	-	$	-	$	15,226	$	(2,258	)
Nonaccrual loans, net ⁽¹⁾		16,996		-		-		16,996		(2,921	)
Total	$	32,222	$	-	$	-	$	32,222	$	(5,179	)

(1)	Amount is net of a valuation allowance of $1.2 million at September 30, 2014 and $1.2 million at December 31, 2013 as required by ASC 310-10, "Receivables."

In the case of the investment securities portfolio, Pinnacle Financial monitors the portfolio to ascertain when transfers between levels have been affected. The nature of the remaining assets and liabilities is such that transfers in and out of any level are expected to be rare. For the nine months ended September 30, 2014, there were no transfers between Levels 1, 2 or 3.

The table below includes a rollforward of the balance sheet amounts for the three and nine months ended September 30, 2014 (including the change in fair value) for financial instruments classified by Pinnacle Financial within Level 3 of the valuation hierarchy for assets and liabilities measured at fair value on a recurring basis. When a determination is made to classify a financial instrument within Level 3 of the valuation hierarchy, the determination is based upon the significance of the unobservable factors to the overall fair value measurement. However, since Level 3 financial instruments typically include, in addition to the unobservable or Level 3 components, observable components (that is, components that are actively quoted and can be validated to external sources), the gains and losses in the table below include changes in fair value due in part to observable factors that are part of the valuation methodology (in thousands):

	For the nine months ended September 30,
	2014				2013
	Other assets		Other liabilities		Other assets			Other liabilities
Fair value, January 1	$	6,701	$	-	$	4,681		$	-
Total realized gains (losses) included in income		406		-		(366	)		-
Change in unrealized gains/losses included in other comprehensive income for assets and liabilities still held at September 30		-		-		-			-
Purchases		357		-		1,650			-
Issuances		-		-		-			-
Settlements		-		-		-			-
Transfers out of Level 3		-		-		-			-
Fair value, September 30	$	7,464	$	-	$	5,965		$	-
Total realized gains (losses) included in income related to financial assets and liabilities still on the consolidated balance sheet at September 30	$	406	$	-	$	(366	)	$	-

The following methods and assumptions were used by Pinnacle Financial in estimating its fair value disclosures for financial instruments that are not measured at fair value. In cases where quoted market prices are not available, fair values are based on estimates using discounted cash flow models. Those models are significantly affected by the assumptions used, including the discount rates, estimates of future cash flows and borrower creditworthiness. The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2014 and December 31, 2013. Such amounts have not been revalued for purposes of these consolidated financial statements since those dates and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

Securities held-to-maturity - Estimated fair values for investment securities are based on quoted market prices where available. If quoted market prices are not available, then fair values are estimated by using pricing models that use observable inputs or quoted prices of securities with similar characteristics.

Loans, net - The fair value of our loan portfolio includes a credit risk factor in the determination of the fair value of our loans. This credit risk assumption is intended to approximate the fair value that a market participant would realize in a hypothetical orderly transaction. Our loan portfolio is initially fair valued using a segmented approach. We divide our loan portfolio into the following categories: variable rate loans, impaired loans and all other loans. The results are then adjusted to account for credit risk.

For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values approximate carrying values. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral. For other loans, fair values are estimated using discounted cash flow models, using current market interest rates offered for loans with similar terms to borrowers of similar credit quality. The values derived from the discounted cash flow approach for each of the above portfolios are then further discounted to incorporate credit risk to determine the exit price.

Mortgage loans held-for-sale - Mortgage loans held-for-sale are carried at the lower of cost or fair value. The estimate of fair value is based on pricing models and other information.

Deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (FHLB) advances, subordinated debt and other borrowings - The carrying amounts of demand deposits, savings deposits, securities sold under agreements to repurchase, floating rate advances from the FHLB, floating rate subordinated debt and other borrowings, and floating rate loans approximate their fair values due to having no stated maturity. Fair values for certificates of deposit, fixed rate advances from the FHLB and fixed rate subordinated debt are estimated using discounted cash flow models, using current market interest rates offered on certificates, advances and other borrowings with similar remaining maturities. For fixed rate subordinated debt, the maturity is assumed to be as of the earliest date that the indebtedness will be repriced.

Off-balance sheet instruments - The fair values of Pinnacle Financial's off-balance-sheet financial instruments are based on fees charged to enter into similar agreements. However, commitments to extend credit do not represent a significant value to Pinnacle Financial until such commitments are funded.

The following table presents the carrying amounts, estimated fair value and placement in the fair value hierarchy of Pinnacle Financial's financial instruments at September 30, 2014 and December 31, 2013. This table excludes financial instruments for which the carrying amount approximates fair value. For short-term financial assets such as cash and cash equivalents, the carrying amount is a reasonable estimate of fair value due to the relatively short time between the origination of the instrument and its expected realization. For financial liabilities such as non-interest bearing demand, interest-bearing demand, and savings deposits, the carrying amount is a reasonable estimate of fair value due to these products having no stated maturity (in thousands).

September 30, 2014	Carrying/ Notional Amount		Estimated Fair Value⁽¹⁾		Quoted market prices in an active market (Level 1)		Models with significant observable market parameters (Level 2)		Models with significant unobservable market parameters (Level 3)
Financial assets:
Securities held-to-maturity	$	38,107	$	38,112	$	-	$	38,112	$	-
Loans, net		4,355,091		4,244,502		-		-		4,244,502
Mortgage loans held-for-sale		19,130		19,428		-		19,428		-

Financial liabilities:
Deposits and securities sold under
agreements to repurchase		4,727,103		4,432,623		-		-		4,432,623
Federal Home Loan Bank advances		215,524		215,390		-		-		215,390
Subordinated debt and other borrowings		96,783		77,887		-		-		77,887

Off-balance sheet instruments:
Commitments to extend credit ⁽²⁾		1,339,618		1,112		-		-		1,112
Standby letters of credit ⁽³⁾		69,851		260		-		-		260


December 31, 2013
Financial assets:
Securities held-to-maturity	$	39,796	$	38,817	$	-	$	38,817	$	-
Loans, net		4,076,524		4,021,675		-		-		4,021,675
Mortgage loans held for sale		12,850		12,999		-		12,999		-

Financial liabilities:
Deposits and securities sold under
agreements to repurchase		4,603,938		4,378,805		-		-		4,378,805
Federal Home Loan Bank advances		90,637		90,652		-		-		90,652
Subordinated debt and other borrowings		98,658		73,083		-		-		73,083

Off-balance sheet instruments:
Commitments to extend credit ⁽²⁾		1,206,528		1,040		-		-		1,040
Standby letters of credit ⁽³⁾		69,231		331		-		-		331

(1)	Estimated fair values are consistent with an exit-price concept. The assumptions used to estimate the fair values are intended to approximate those that a market-participant would realize in a hypothetical orderly transaction.

(2)

At the end of each quarter, Pinnacle Financial evaluates the inherent risks of the outstanding off-balance sheet commitments. In making this evaluation, Pinnacle Financial evaluates the credit worthiness of the borrower, the collateral supporting the commitments and any other factors similar to those used to evaluate the inherent risks of our loan portfolio. Additionally, Pinnacle Financial evaluates the probability that the outstanding commitment will eventually become a funded loan. As a result, at September 30, 2014 and December 31, 2013, Pinnacle Financial included in other liabilities $1.1 million and $1.0 million, respectively, representing the inherent risks associated with these off-balance sheet commitments.

(3)

At September 30, 2014 and December 31, 2013, the fair value of Pinnacle Financial's standby letters of credit was $260,000 and $331,000, respectively. This amount represents the unamortized fee associated with these standby letters of credit and is included in the consolidated balance sheet of Pinnacle Financial and is believed to approximate fair value. This fair value will decrease over time as the existing standby letters of credit approach their expiration dates.