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FAIR VALUE ACCOUNTING
9 Months Ended
Sep. 30, 2012
FAIR VALUE ACCOUNTING

10. FAIR VALUE ACCOUNTING

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC 825 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy under ASC 825 are described below:

Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

Level 2 – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, prepayment speeds, volatilities, etc.) or model-based valuation techniques where all significant assumptions are observable, either directly or indirectly, in the market;

Level 3 – Valuation is generated from model-based techniques where all significant assumptions are not observable, either directly or indirectly, in the market. These unobservable assumptions reflect an entity’s own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques may include use of matrix pricing, discounted cash flow models and similar techniques.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value is set forth below. Transfers between levels in the fair value hierarchy are recognized at the end of the reporting period.

Under ASC Topic 825, the Company elected the fair value option (“FVO”) treatment for the junior subordinated debt and certain investment securities. This election is generally irrevocable and unrealized gains and losses on these items must be reported in earnings at each reporting date. The Company continues to account for these items under the fair value option. Since adoption, there were no financial instruments purchased by the Company which met the ASC 825 fair value election criteria, and therefore, no additional instruments have been added under the fair value option election.

All securities for which the fair value measurement option had been elected are included in a separate line item on the balance sheet entitled “securities measured at fair value.”

 

For the three and nine months ended September 30, 2012 and 2011, gains and losses from fair value changes included in the Consolidated Statement of Operations were as follows:

 

     Changes in Fair Values for Items Measured at Fair  
     Value Pursuant to Election of the Fair Value Option  

Description

   Unrealized
Gain/(Loss) on
Assets and
Liabilities
Measured at
Fair Value, Net
     Interest
Income on
Securities
     Interest
Expense on
Junior
Subordinated
Debt
     Total
Changes
Included in
Current-
Period
Earnings
 
     (in thousands)  

Three Months Ended September 30, 2012

           

Securities measured at fair value

   $ —         $ 3       $ —         $ 3   

Junior subordinated debt

     469         —           329         140   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 469       $ 3       $ 329       $ 143   
  

 

 

    

 

 

    

 

 

    

 

 

 

Nine Months Ended September 30, 2012

           

Securities measured at fair value

   $ (66)       $ 10       $ —         $ (56)   
  

 

 

    

 

 

    

 

 

    

 

 

 

Junior subordinated debt

     767         —           981         (214)   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 701       $ 10       $ 981       $ (270)   
     Changes in Fair Values for Items Measured at Fair  
     Value Pursuant to Election of the Fair Value Option  

Description

   Unrealized
Gain (Loss) on
Assets and
Liabilities
Measured at
Fair Value, Net
     Interest
Income on
Securities
     Interest
Expense on
Junior
Subordinated
Debt
     Total
Changes
Included in
Current-

Period
Earnings
 
     (in thousands)  

Three Months Ended September 30, 2011

           

Securities measured at fair value

   $ 32       $ 4       $ —         $ 36   

Junior subordinated debt

     6,388         —           267         6,121   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 6,420       $ 4       $ 267       $ 6,157   
  

 

 

    

 

 

    

 

 

    

 

 

 

Nine Months Ended September 30, 2011

           

Securities measured at fair value

   $ 1       $ 22       $ —         $ 23   

Junior subordinated debt

     6,689         —           766         5,923   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 6,690       $ 22       $ 766       $ 5,946   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

The following table presents gains and losses from fair value changes on securities measured at fair value:

 

     Three Months  Ended
September 30,
     Nine Months Ended
September 30,
 
     2012      2011      2012     2011  
     (in thousands)      (in thousands)  

Net gains and (losses) for the period on trading securities included in earnings

   $ —         $ 32       $ (66   $ 1   

Less: net gains and (losses) recognized during the period on trading securities sold during the period

     —           —           —          190   
  

 

 

    

 

 

    

 

 

   

 

 

 

Change in unrealized gains or (losses) for the period included in earnings for trading securities held at the end of the reporting period

   $ —         $ 32       $ (66   $ (189
  

 

 

    

 

 

    

 

 

   

 

 

 

The difference between the aggregate fair value of junior subordinated debt ($36.2 million) and the aggregate unpaid principal balance thereof ($66.5 million) was $30.3 million at September 30, 2012.

Interest income on securities measured at fair value is accounted for similarly to those classified as available-for-sale and held-to-maturity. Any premiums or discounts are recognized in interest income over the term of the securities. For mortgage-backed securities, estimates of prepayments are considered in the constant yield calculations. Interest expense on junior subordinated debt is also determined under a constant yield calculation.

Fair value on a recurring basis

Financial assets and financial liabilities measured at fair value on a recurring basis include the following:

AFS Securities: Adjustable-rate preferred securities, one trust preferred security, corporate debt securities and CRA mutual fund investments are reported at fair value utilizing Level 1 inputs. Other securities classified as AFS are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Securities measured at fair value: All of the Company’s securities measured at fair value, the majority of which are mortgage-backed securities, are reported at fair value utilizing Level 2 inputs in the same manner as described above for securities available for sale.

Independent pricing service: Management independently evaluates all of the fair value measurements received from our third party pricing service through multiple review steps. First, management reviews what has transpired in the market-place with respect to interest rates, credit spreads, volatility, mortgage rates, etc., and makes an expectation on changes to the securities valuations from the previous quarter. Then management compares expected changes to the actual valuation changes provided to it by its pricing service. Next, management compares a robust sampling of safekeeping marks on securities with the marks provided by our third party pricing service and determines whether there are any notable differences. Then, management compares the prices on Level 1 priced securities to publically available prices to verify those prices are similar. Finally, management discusses the assumptions used for Level 2 priced securities with our pricing service. The pricing service provides management with observable market data including interest rate curves and mortgage prepayment speed grids, as well as dealer quote sheets, new bond offering sheets, and historical trade documentation. Management reviews the assumptions and decides whether they are reasonable. Management may compare interest rates, credit spreads and prepayments speeds used as part of the assumptions to those that management believes are reasonable. Management may price securities using the provided assumptions to determine whether they can develop similar prices on like securities. Any discrepancies with management’s review and the prices provided by the vendor are discussed with the vendor and the Company’s other valuation advisors. Management has formally challenged the prices on several securities, but has found that the vendor prices are reasonable.

Annually the Company receives a SSAE 16 report from its independent pricing service attesting to the controls placed on the operations of the service from its auditor.

Interest rate swap: Interest rate swaps are reported at fair value utilizing Level 2 inputs. The Company obtains dealer quotations to value its interest rate swaps.

Junior subordinated debt: The Company estimates the fair value of its junior subordinated debt using a discounted cash flow model which incorporates the effect of the Company’s own credit risk in the fair value of the liabilities (Level 3). The Company’s cash flow assumptions were based on the contractual cash flows as the Company anticipates that it will pay the debt according to its contractual terms. The Company evaluated priced offerings on individual issuances of trust preferred securities and estimated the discount rate based, in part, on that information. The Company estimated the discount rate at 6.53%, which is a 617 basis point spread over 3 month LIBOR (0.359% as of September 30, 2012). As of September 30, 2011, the Company estimated the discount rate at 6.754%, which was a 638 basis point spread over 3 month LIBOR (0.374%). As of December 31, 2011, the Company estimated the discount rate at 6.989%, which was a 641 basis point spread over 3 month LIBOR (0.579%).

 

Securities sold short:: Securities sold short, comprised of entirely U.S. Treasury bonds are reported at fair value utilizing Level 1 inputs.

The fair value of these assets and liabilities were determined using the following inputs at the periods presented:

 

     Fair Value Measurements at the End of the Reporting  Period Using:  

September 30, 2012

   Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
     Fair Value  
     (in thousands)  

Assets:

        

Securities measured at fair value

           

Direct U.S. obligations and GSE residential mortgage-backed securities

   $ —         $ 5,505       $ —         $ 5,505   
  

 

 

    

 

 

    

 

 

    

 

 

 

Securities available for sale

           

Municipal obligations

   $ —         $ 60,002         —         $ 60,002   

Direct U.S. obligations and GSE residential mortgage-backed securities

     —           803,349         —           803,349   

Mutual funds

     31,042         —           —           31,042   

Private label residential mortgage-backed securities

     —           20,775         —           20,775   

Private label commercial mortgage-backed securities

     —           5,720         —           5,720   

Adjustable-rate preferred stock

     71,035         —           —           71,035   

Trust preferred

     22,892            —           22,892   

Corporate bonds

     5,002         —           —           5,002   

Other

     24,320         —           —           24,320   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 154,291       $ 889,846       $ —         $ 1,044,137   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest rate swaps

   $ —         $ 858       $ —         $ 858   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities:

           

Junior subordinated debt

   $ —         $ —         $ 36,218       $ 36,218   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest rate swaps

   $ —         $ 831       $ —         $ 831   
  

 

 

    

 

 

    

 

 

    

 

 

 

Securities sold short

   $ 138,287       $ —         $ —         $ 138,287   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     Fair Value Measurements at the End of the Reporting  Period Using  
     Quoted Prices                       
     in Active      Significant                
     Markets for      Other      Significant         
     Identical      Observable      Unobservable         
     Assets      Inputs      Inputs      Fair  

December 31, 2011

   (Level 1)      (Level 2)      (Level 3)      Value  
            (in thousands)         

Assets:

        

Securities measured at fair value

           

Direct U.S. obligations and GSE residential mortgage-backed securities

   $ —         $ 6,515       $ —         $ 6,515   
  

 

 

    

 

 

    

 

 

    

 

 

 

Securities available for sale

           

U.S. Government-sponsored agency securities

   $ —         $ 156,211       $ —         $ 156,211   

Municipal obligations

     —           5,586         —           5,586   

Direct U.S. obligations and GSE residential mortgage-backed securities

     —           864,584         —           864,584   

Mutual funds

     28,864         —           —           28,864   

Private label residential mortgage-backed securities

     —           25,784         —           25,784   

Private label commercial mortgage-backed securities

     —           5,431            5,431   

Adjustable-rate preferred stock

     54,676         —           —           54,676   

Trust preferred

     1,323         19,836         —           21,159   

Corporate bonds

     4,575         —           —           4,575   

Other

     23,515         —           —           23,515   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 112,953       $ 1,077,432       $ —         $ 1,190,385   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest rate swaps

   $ —         $ 1,729       $ —         $ 1,729   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities:

           

Junior subordinated debt

   $ —         $ —         $ 36,985       $ 36,985   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest rate swaps

   $ —         $ 946       $ —         $ 946   
  

 

 

    

 

 

    

 

 

    

 

 

 

For the nine months ended September 30, 2012, the change in Level 3 liabilities measured at fair value on a recurring basis was as follows:

 

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)

 
     Junior  
     Subordinated  
     Debt  
     (in thousands)  

Opening balance

   $ (36,985

Transfers into Level 3

     —     

Transfers out of Level 3

     —     

Total gains or losses for the period

  

Included in earnings (or changes in net assets) (a)

     767   

Included in other comprehensive income

     —     

Purchases, sales, and settlements

     —     

Purchases

     —     

Sales

     —     

Settlements

     —     
  

 

 

 

Closing balance

   $ (36,218
  

 

 

 

Change in unrealized gains (losses) for the nine month period included in earnings (or changes in net assets) for the period ended September 30, 2012.

   $ 767   
  

 

 

 

Change in unrealized gains (losses) for the nine month period included in earnings (or changes in net assets) for the period ended September 30, 2011.

   $ 6,689   
  

 

 

 

 

(a) Total gains (losses) for the period are included in the non-interest income line, mark to market gains (losses), net.

 

For Level 3 liabilities measured at fair value on a recurring basis as of September 30, 2012, the significant unobservable inputs used in the fair value measurements were as follows:

 

     Fair Value at      Valuation      Significant       
     September 30,2012      Technique     

Unobservable Inputs

   Input Value  
     (dollars in thousands)  

Junior subordinated debt

   $ 36,218         Discounted cash flow       Median market spreads on publicly issued trust preferreds with comparable credit risk      6.53

 

     Fair Value at      Valuation      Significant       
     December 31,2011      Technique     

Unobservable Inputs

   Input Value  
     (dollars in thousands)  

Junior subordinated debt

   $ 36,985         Discounted cash flow       Median market spreads on publicly issued trust preferreds with comparable credit risk      6.989

The significant unobservable inputs used in the fair value measurement of the Company’s junior subordinated debt are the calculated or estimated credit spreads on comparable publicly traded company trust preferred issuances which were non-investment grade and non-rated. Significant increases (decreases) in these inputs could result in a significantly higher (lower) fair value measurement.

Fair value on a nonrecurring basis

Certain assets are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis, but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following table presents such assets carried on the balance sheet by caption and by level within the ASC 825 hierarchy:

 

     Fair Value Measurements at the End of the Reporting  Period Using  
            Quoted Prices                
            in Active      Active         
            Markets for      Markets for      Unobservable  
            Identical Assets      Similar Assets      Inputs  
     Total      (Level 1)      (Level 2)      (Level 3)  
     (in thousands)  

As of September 30, 2012:

           

Impaired loans with specific valuation allowance

   $ 43,469       $ —         $ —         $ 43,469   

Impaired loans without specific valuation allowance

     68,512         —           —           68,512   

Other assets acquired through foreclosure

     78,234         —           —           78,234   

As of December 31, 2011:

           

Impaired loans with specific valuation allowance

   $ 18,254       $ —         $ —         $ 18,254   

Impaired loans without specific valuation allowance

     71,001         —           —           71,001   

Other assets acquired through foreclosure

     89,104         —           —           89,104   

Impaired loans: The specific reserves for collateral dependent impaired loans are based on the fair value of the collateral. The fair value of collateral is determined based on third-party appraisals. Appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Fair value is determined, where possible, using market prices derived from an appraisal or evaluation, which are considered to be Level 2. However, certain assumptions and unobservable inputs are often used by the appraiser; therefore, qualifying the assets as Level 3 in the fair value hierarchy. In some cases, adjustments are made to the appraised values due to various factors, including age of the appraisal (which are generally obtained every six to twelve months), age of comparables included in the appraisal, and known changes in the market and in the collateral. When significant adjustments are based on unobservable inputs, such as when a current appraised value is not available or management determines the fair value of the collateral is further impaired below appraised value and there is no observable market price, the resulting fair value measurement has been categorized as a Level 3 measurement. These Level 3 impaired loans had an aggregate carrying amount of $58.9 million and specific reserves in the allowance for loan losses of $15.4 million at September 30, 2012.

 

Other assets acquired through foreclosure: Other assets acquired through foreclosure consist of properties acquired as a result of, or in-lieu-of, foreclosure. Properties or other assets classified as other assets acquired through foreclosure and other repossessed property and are initially reported at the fair value determined by independent appraisals using appraised value, less cost to sell. Such properties are generally re-appraised every six to twelve months. There is risk for subsequent volatility. Costs relating to the development or improvement of the assets are capitalized and costs relating to holding the assets are charged to expense. The Company had $78.2 million of such assets at September 30, 2012. Fair value is determined, where possible, using market prices derived from an appraisal or evaluation, which are considered to be Level 2. However, certain assumptions and unobservable inputs are often used by the appraise;, therefore, qualifying the assets as Level 3 in the fair value hierarchy. When significant adjustments are based on unobservable inputs, such as when a current appraised value is not available or management determines the fair value of the collateral is further impaired below appraised value and there is no observable market price, the resulting fair value measurement has been categorized as a Level 3 measurement.

Credit vs. non-credit losses

The Company elected to apply provisions of ASC 320 as of January 1, 2009 to its AFS and HTM investment securities portfolios. The OTTI was separated into (a) the amount of total impairment related to the credit loss, and (b) the amount of the total impairment related to all other factors. The amount of the total OTTI related to the credit loss was recognized in earnings. The amount of the total impairment related to all other factors was recognized in other comprehensive income. The OTTI was presented in the statement of operations with an offset for the amount of the total OTTI that was recognized in other comprehensive income.

If the Company does not intend to sell and it is not more likely than not that the Company will be required to sell the impaired securities before recovery of the amortized cost basis, the Company recognizes the cumulative effect of initially applying this FASB Staff Position (“FSP”) as an adjustment to the opening balance of retained earnings with a corresponding adjustment to accumulated other comprehensive income, including related tax effects. The Company elected to early adopt ASC 320 on its impaired securities portfolio since it provides more transparency in the consolidated financial statements related to the bifurcation of the credit and non-credit losses.

For the three and nine months ended September 30, 2012, the Company determined that no securities contained credit losses. For the three and nine months ended September 30, 2011, the Company determined that certain collateralized mortgage debt securities contained credit losses. The impairment credit losses related to these debt securities was $0.2 million.

Debt Security Credit Losses

Recognized in Other Comprehensive Income/Earnings

For the Nine Months Ended September 30, 2012 and 2011

 

     Private Label Mortgage-  
     Backed Securities  
     (in thousands)  

Beginning balance of impairment losses held in other comprehensive income

   $ (1,811

Current period other-than temporary impairment credit recognized through earnings

     —     

Reductions for securities sold during the period

     —     

Additions or reductions in credit losses due to change of intent to sell

     —     

Reductions for increases in cash flows to be collected on impaired securities

     —     
  

 

 

 

Ending balance of net unrealized gains and (losses) held in other comprehensive income

   $ (1,811
  

 

 

 

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

The estimated fair value of the Company’s financial instruments is as follows:

 

     September 30,2012      December 31, 2011  
     Carrying      Fair Value      Carrying      Fair  
     Amount      Level 1      Level 2      Level 3      Total      Amount      Value  
                          (in thousands)                       

Financial assets:

                    

Investment securities

   $ 1,333,114       $ 251,848       $ 1,081,386       $ —         $ 1,333,234       $ 1,483,158       $ 1,486,935   

Derivatives

     858         —           858         —           858         1,729         1,729   

Loans, net

     5,235,522         —           4,783,498         111,981         4,895,479         4,680,899         4,420,006   

Financial liabilities:

                    

Deposits

     6,161,976         —           6,162,746         —           6,162,746         5,658,512         5,660,518   

Customer repurchases

     73,063         —           73,063         —           73,063         123,626         123,626   

FHLB and FRB advances

     150,000         —           150,000         —           150,000         280,000         280,000   

Other borrowed funds

     73,614         —           —           81,075         81,075         73,321         78,375   

Junior subordinated debt

     36,218         —           —           36,218         36,218         36,985         36,985   

Derivatives

     831         —           831         —           831         946         946   

Interest rate risk

The Company assumes interest rate risk (the risk to the Company’s earnings and capital from changes in interest rate levels) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments as well as its future net interest income will change when interest rate levels change and that change may be either favorable or unfavorable to the Company.

Interest rate risk exposure is measured using interest rate sensitivity analysis to determine our change in net portfolio value and net interest income resulting from hypothetical changes in interest rates. If potential changes to net portfolio value and net interest income resulting from hypothetical interest rate changes are not within the limits established by the Board of Directors, the Board of Directors may direct management to adjust the asset and liability mix to bring interest rate risk within board-approved limits. As of September 30, 2012, the Company’s interest rate risk profile was within Board-approved limits.

Each of the Company’s subsidiary banks has an Asset and Liability Management Committee charged with managing interest rate risk within Board approved limits. Such limits may vary by bank based on local strategy and other considerations, but in all cases, are structured to prohibit an interest rate risk profile that is significantly asset or liability sensitive. There also exists an Asset and Liability Management Committee at the holding company level that reviews the interest rate risk of each subsidiary bank, as well as an aggregated position for the entire Company.

Fair value of commitments

The estimated fair value of standby letters of credit outstanding at September 30, 2012 and December 31, 2011 was insignificant. Loan commitments on which the committed interest rates were less than the current market rate are also insignificant at September 30, 2012 and December 31, 2011.