Note 10. 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. generally accepted accounting principles 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.

Valuation Hierarchy

FASB ASC 820 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Following is a description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such assets and liabilities pursuant to the valuation hierarchy.

Assets

Securities available-for-sale – Where quoted prices are available for identical securities in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government securities and certain other financial products. 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 and are classified within Level 2 of the valuation hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation and more complex pricing models or discounted cash flows are used, securities are classified within Level 3 of the valuation hierarchy.

Impaired loans – A loan is considered to be impaired when it is probable Pinnacle Financial will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected payments using the loan's original effective rate as the discount rate, the loan's observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent. If the recorded investment in the impaired loan exceeds the measure of fair value, a valuation allowance may be established as a component of the allowance for loan losses or the expense is recognized as a charge-off. Impaired loans are classified within Level 3 of the hierarchy.

Other investments – Included in other investments are investments in certain nonpublic private equity funds. The valuation of nonpublic private equity investments requires significant management judgment due to the absence of quoted market prices, inherent lack of liquidity and the long-term nature of such assets. These investments are valued initially based upon transaction price. The carrying values of other investments are adjusted either upwards or downwards from the transaction price to reflect expected exit values as evidenced by financing and sale transactions with third parties, or when determination of a valuation adjustment is confirmed through ongoing reviews by senior investment managers. A variety of factors are reviewed and monitored to assess positive and negative changes in valuation including, but not limited to, current operating performance and future expectations of the particular investment, industry valuations of comparable public companies and changes in market outlook and the third-party financing environment over time. In determining valuation adjustments resulting from the investment review process, emphasis is placed on current company performance and market conditions. These investments are included in Level 3 of the valuation hierarchy.

Other real estate owned – Other real estate owned (OREO) represents real estate foreclosed upon by Pinnacle National through loan defaults by customers. Substantially all of these amounts relate to lots, homes and development projects that are either completed or are in various stages of construction for which Pinnacle Financial believes it has adequate collateral. Upon foreclosure, the property is recorded at the lower of cost or fair value, based on appraised value, less selling costs estimated as of the date acquired with any loss recognized as a charge-off through the allowance for loan losses. Additional OREO losses for subsequent valuation downward adjustments are determined on a specific property basis and are included as a component of noninterest expense along with holding costs. Any gains or losses realized at the time of disposal are reflected in noninterest expense, as applicable. Other real estate owned is included in Level 3 of the valuation hierarchy.

Other assets – Included in other assets are certain assets carried at fair value, including the cash surrender value of bank owned life insurance policies and interest rate swap agreements. The carrying amount of the cash surrender value of bank owned life insurance is based on information received from the insurance carriers indicating the financial performance of the policies and the amount Pinnacle Financial would receive should the policies be surrendered. Pinnacle Financial reflects these assets within Level 3 of the valuation hierarchy. The carrying amount of interest rate swap agreements is based on Pinnacle Financial's pricing models that utilize observable market inputs obtained from a third party bank. Pinnacle Financial reflects these assets within Level 2 of the valuation hierarchy.

Liabilities

Other liabilities – Pinnacle Financial has certain liabilities carried at fair value including certain interest rate swap agreements. The fair value of these liabilities is based on Pinnacle Financial's pricing models that utilize observable market inputs obtained from a third party bank and is reflected within Level 2 of the valuation hierarchy.

The following tables present the financial instruments carried at fair value as of September 30, 2011 and December 31, 2010, by caption on the consolidated balance sheets and by FASB ASC 820 valuation hierarchy (as described above) (in thousands):

Assets and liabilities measured at fair value on a recurring basis as of September 30, 2011

	Total carrying value in the consolidated balance sheet		Quoted market prices in an active market		Models with significant observable market parameters		Models with significant unobservable market parameters
			(Level 1)		(Level 2)		(Level 3)
Investment securities available-for-sale:
U.S. government agency securities	$	40,435	$	-	$	40,435	$	-
Mortgage-backed securities		685,600		-		685,600		-
State and municipal securities		202,954		-		202,954		-
Corporate notes and other		11,173		-		11,173		-
Total investment securities available-for-sale		940,162		-		940,162		-
Other investments		3,370		-		-		3,370
Other assets		68,161		-		19,046		49,115
Total assets at fair value	$	1,011,693	$	-	$	959,208	$	52,485

Other liabilities	$	19,252	$	-	$	19,252	$	-
Total liabilities at fair value	$	19,252	$	-	$	19,252	$	-

Assets and liabilities measured at fair value on a recurring basis as of December 31, 2010

	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. government agency securities	$	90,415	$	-	$	90,415	$	-
Mortgage-backed securities		701,262		-		701,262		-
State and municipal securities		211,481		-		211,481		-
Corporate notes and other		11,159		-		11,159		-
Total investment securities available-for-sale		1,014,317		-		1,014,317		-
Other investments		2,693		-		-		2,693
Other assets		62,710		-		14,441		48,269
Total assets at fair value	$	1,079,720	$	-	$	1,028,758	$	50,962

Other liabilities	$	14,639	$	-	$	14,639	$	-
Total liabilities at fair value	$	14,639	$	-	$	14,639	$	-

Assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2011

	Total carrying value in the consolidated balance sheet		Quoted market prices in an active market		Models with significant observable market parameters		Models with significant unobservable market parameters		Total gains (losses) for the quarter ended September 30,			Total gains (losses ) for the nine months ended September 30,
			(Level 1)		(Level 2)		(Level 3)		2011			2011
Other real estate owned	$	45,500	$	-	$	-	$	45,500	$	(2,985	)	$	(5,224	)
Impaired loans, net (1)		49,134		-		-		49,134		(4,430	)		(8,481	)
Total	$	96,634	$	-	$	-	$	96,634	$	(7,415	)	$	(13,705	)

(1)

Amount is net of a valuation allowance of $5.5 million as required by ASC 310-10, “Receivables.”

Assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2010

	Total carrying value in the consolidated balance sheet		Quoted market prices in an active market		Models with significant observable market parameters		Models with significant unobservable market parameters		Total gains (losses) for the year ended December 31,
			(Level 1)		(Level 2)		(Level 3)		2010
Other real estate owned	$	59,608	$	-	$	-	$	59,608	$	(11,365	)
Impaired loans, net (2)		71,906		-		-		71,906		(11,446	)
Total	$	131,514	$	-	$	-	$	131,514	$	(22,811	)

(2)

Amount is net of a valuation allowance of $8.9 million as required by ASC 310-10, “Receivables.”

In the case of the bond portfolio, Pinnacle Financial monitors the valuation technique utilized by various pricing agencies 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, 2011, there were no transfers between Levels 1, 2 or 3.

The table below includes a rollforward of the balance sheet amounts for the nine months ended September 30, 2011 (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):

	Nine months ended September 30,
	2011				2010
	Other assets		Other liabilities		Other assets		Other liabilities
Fair value, January 1	$	50,962	$	-	$	49,518	$	-
Total realized gains included in income		1,130		-		766		-
Change in unrealized gains/losses included in other comprehensive income for assets and liabilities still held at September 30		-		-		-		-
Purchases, issuances and settlements, net		393		-		422		-
Transfers out of Level 3		-		-		-		-
Fair value, September 30	$	52,485	$	-	$	50,706	$	-
Total realized gains included in income related to financial assets and liabilities still on the consolidated balance sheet at September 30	$	1,130	$	-	$	766	$	-

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, 2011 and December 31, 2010. 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.

Cash and cash equivalents - The carrying amounts of cash, due from banks, federal funds sold, and short-term discount notes sold approximate their fair value due to their short-term nature.

Securitiesheld-to-maturity and available-for-sale - 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 - Beginning in the second quarter of 2011, Pinnacle incorporated a component of credit risk into our determination of the fair value of our loans. The addition of 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 equal to the carrying value of these loans as they are usually sold within a few weeks of their origination.

Deposits, Securities Sold Under Agreements to Repurchase, Federal Home Loan Bank Advances and Subordinated Debt - The carrying amounts of demand deposits, savings deposits, securities sold under agreements to repurchase, floating rate advances from the Federal Home Loan Bank and floating rate subordinated debt approximate their fair values. Fair values for certificates of deposit, fixed rate advances from the Federal Home Loan Bank 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. Pinnacle Financial has determined that the fair value of commitments to extend credit is not significant.

The carrying amounts and estimated fair values of Pinnacle Financial's financial instruments at September 30, 2011 and December 31, 2010 were as follows (in thousands):

	September 30, 2011				December 31, 2010
	Carrying Amount		Estimated Fair Value (1)		Carrying Amount		Estimated Fair Value (1)
Financial assets:
Cash and cash equivalents	$	180,535	$	180,535	$	188,586	$	188,586
Securities available-for-sale		940,162		940,162		1,014,317		1,014,317
Securities held-to-maturity		2,590		2,641		4,320		4,412
Mortgage loans held-for-sale		23,814		23,814		16,206		16,206
Loans, net (2)		3,166,278		2,857,638		3,129,865		2,874,894
Derivative assets		19,045		19,045		14,441		14,441
Bank owned life insurance		48,598		48,598		47,724		47,724
Other investments		3,370		3,370		2,693		2,693

Financial liabilities:
Deposits and securities sold under agreements to repurchase	$	3,841,604	$	3,813,527	$	3,979,352	$	3,974,408
Federal Home Loan Bank advances		161,106		161,665		121,393		126,399
Subordinated debt		97,476		71,389		97,476		75,360
Derivative liabilities		19,252		19,252		14,639		14,639

	Notional Amount		Estimated Fair Value		Notional Amount		Estimated Fair Value
Off-balance sheet instruments:
Commitments to extend credit (3)	$	839,159	$	1,400	$	848,023	$	998
Standby letters of credit (4)		82,448		423		75,172		275

(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)

The estimated fair value of loans included in the table above includes a credit risk adjustment of approximately $316 million and $310 million, respectively, at September 30, 2011 and at December 31, 2010, respectively. The December 31, 2010 fair value of loans has been adjusted to incorporate the credit risk adjustment.

(3)

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, 2011, Pinnacle Financial included in other liabilities $1.4 million representing the inherent risks associated with these off-balance sheet commitments.

(4)

At September 30, 2011, the fair value of Pinnacle Financial's standby letters of credit was $423,000. This amount represents the unamortized fee associated with these standby letters of credit and is included in the consolidated balance sheet of Pinnacle Financial. This fair value will decrease over time as the existing standby letters of credit approach their expiration dates.