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Fair Value

6 Months Ended

Jun. 30, 2020

FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (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. There are three levels of inputs that may be used to measure fair values:

•Level 1 – Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

•Level 2 – Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

•Level 3 – Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Old National used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using swap and LIBOR curves plus spreads that adjust for loss severities, volatility, credit risk, and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Residential loans held for sale: The fair value of loans held for sale is determined using quoted prices for a similar asset, adjusted for specific attributes of that loan (Level 2).

Derivative financial instruments: The fair values of derivative financial instruments are based on derivative valuation models using market data inputs as of the valuation date (Level 2).

Recurring Basis

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


			Fair Value Measurements at June 30, 2020 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Equity securities	$	40,246	$	40,246	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury	35,731		35,731		—		—
U.S. government-sponsored entities and agencies	453,501		—		453,501		—
Mortgage-backed securities - Agency	3,304,054		—		3,304,054		—
States and political subdivisions	1,355,959		—		1,355,959		—
Pooled trust preferred securities	7,185		—		—		7,185
Other securities	290,841		—		290,841		—
Residential loans held for sale	122,507		—		122,507		—
Derivative assets	165,366		—		165,366		—
Financial Liabilities
Derivative liabilities	22,425		—		22,425		—


			Fair Value Measurements at December 31, 2019 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Equity securities	$	6,842	$	6,842	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury	17,682		17,682		—		—
U.S. government-sponsored entities and agencies	592,984		—		592,984		—
Mortgage-backed securities - Agency	3,183,861		—		3,183,861		—
States and political subdivisions	1,275,643		—		1,275,603		40
Pooled trust preferred securities	8,222		—		—		8,222
Other securities	306,699		31,169		275,530		—
Residential loans held for sale	46,898		—		46,898		—
Derivative assets	51,301		—		51,301		—
Financial Liabilities
Derivative liabilities	12,393		—		12,393		—

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):


(dollars in thousands)	Pooled Trust Preferred Securities		States and Political Subdivisions
Three Months Ended June 30, 2020
Balance at beginning of period	$	7,422	$	—
Accretion of discount	3		—
Sales/payments received	(16)		—
Decrease in fair value of securities	(224)		—
Balance at end of period	$	7,185	$	—

Three Months Ended June 30, 2019
Balance at beginning of period	$	8,123	$	40
Accretion of discount	3		—
Sales/payments received	(17)		—
Decrease in fair value of securities	(273)		—

Balance at end of period	$	7,836	$	40

Six Months Ended June 30, 2020
Balance at beginning of period	$	8,222	$	40
Accretion of discount	7		—
Sales/payments received	(33)		(40)
Decrease in fair value of securities	(1,011)		—

Balance at end of period	$	7,185	$	—

Six Months Ended June 30, 2019
Balance at beginning of period	$	8,495	$	4,108
Accretion of discount	7		—
Sales/payments received	(32)		(35)
Decrease in fair value of securities	(634)		—
Transfers out of Level 3	—		(4,033)
Balance at end of period	$	7,836	$	40

The accretion of discounts on securities in the table above is included in interest income. The decrease in the fair value of securities in the table above is included in the unrealized holding gains (losses) for the period in the statement of other comprehensive income. A decrease in fair value is reflected in the balance sheet as a decrease in the fair value of investment securities available-for-sale, a decrease in accumulated other comprehensive income, which is included in shareholders’ equity, and an increase in other assets related to the tax impact. During the six months ended June 30, 2019, Old National received third party pricing on a $4.0 million state and political subdivisions security and transferred it out of Level 3.

The table below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 of the fair value hierarchy:

(dollars in thousands)

Fair Value

Valuation Techniques

Unobservable Input

Range (Weighted Average) (4)

June 30, 2020

Pooled trust preferred securities

7,185

Discounted cash flow

Constant prepayment rate (1)

0.00%

Additional asset defaults (2)

6.0% - 8.9% (6.9%)

Expected asset recoveries (3)

0.0% - 18.7% (5.9%)

December 31, 2019

Pooled trust preferred securities

8,222

Discounted cash flow

Constant prepayment rate (1)

0.00%

Additional asset defaults (2)

6.2% - 8.0% (6.8%)

Expected asset recoveries (3)

0.0% - 19.1% (6.0%)

State and political subdivisions

Discounted cash flow

No observable inputs

N/A

Local municipality issuance

Old National owns 100%

Carried at par

(1)Assuming no prepayments.

(2)Each currently performing pool asset is assigned a default probability based on the banking environment, which is adjusted for specific issuer evaluation, of 0%, 50%, or 100%.

(3)Each currently defaulted pool asset is assigned a recovery probability based on specific issuer evaluation of 0%, 25%, or 100%.

(4)Unobservable inputs are weighted by the estimated number of defaults and current performing collateral of the instruments.

Significant changes in any of the unobservable inputs used in the fair value measurement in isolation would have resulted in a significant change to the fair value measurement. The pooled trust preferred securities Old National owns are subordinate note classes that rely on an ongoing cash flow stream to support their values. The senior note classes receive the benefit of prepayments to the detriment of subordinate note classes since the ongoing interest cash flow stream is reduced by the early redemption. Generally, a change in prepayment rates or additional pool asset defaults would have an impact that is directionally opposite from a change in the expected recovery of a defaulted pool asset.

Non-Recurring Basis

Assets measured at fair value on a non-recurring basis are summarized below:


			Fair Value Measurements at June 30, 2020 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Collateral Dependent Impaired Loans:
Commercial loans	$	13,676	$	—	$	—	$	13,676
Commercial real estate loans	21,880		—		—		21,880
Foreclosed Assets:

Residential	47		—		—		47
Loan servicing rights	24,034		—		24,034		—

Impaired commercial and commercial real estate loans that are deemed collateral dependent are valued based on the fair value of the underlying collateral. These estimates are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property, and other related factors to estimate the current value of the collateral. These impaired commercial and commercial real estate loans had a principal amount of $44.3 million, with a valuation allowance of $8.8 million at June 30, 2020. Old National recorded provision recoveries associated with these loans totaling $0.3 million for the three months ended June 30, 2020 and provision expense totaling $6.5 million for the six months ended June 30, 2020. Old National recorded provision expense associated with impaired commercial and commercial real estate loans that were deemed collateral dependent totaling $1.1 million for the three months ended June 30, 2019 and $2.3 million for the six months ended June 30, 2019.

Other real estate owned and other repossessed property is measured at fair value less costs to sell on a non-recurring basis and had a net carrying amount of $47 thousand at June 30, 2020. There were write-downs of other real estate owned of $87 thousand for the three months ended June 30, 2020 and $98 thousand for the six months ended June 30, 2020. Old National did not record any write-downs for the three or six months ended June 30, 2019.

Loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level, based on market prices for comparable mortgage servicing contracts when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model utilizes a discount rate, weighted average prepayment speed, and other economic factors that market participants would use in estimating future net servicing income and that can be validated against available market data (Level 2). The valuation allowance for loan servicing rights with impairments at June 30, 2020 totaled $2.3 million. Old National recorded impairments associated with these loan servicing rights totaling $0.8 million during the three months ended June 30, 2020 and $2.2 million during the six months ended June 30, 2020. There were impairments of $15 thousand for the three months ended June 30, 2019 and $17 thousand for the six months ended June 30, 2019.

Assets measured at fair value on a non-recurring basis are summarized below:


			Fair Value Measurements at December 31, 2019 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Collateral Dependent Impaired Loans:
Commercial loans	$	10,361	$	—	$	—	$	10,361
Commercial real estate loans	11,610		—		—		11,610
Foreclosed Assets:
Commercial real estate	21		—		—		21
Residential	22		—		—		22
Loan servicing rights	4,662		—		4,662		—

At December 31, 2019, impaired commercial and commercial real estate loans had a principal amount of $30.9 million, with a valuation allowance of $8.9 million.

Other real estate owned and other repossessed property had a net carrying amount of $43 thousand at December 31, 2019.

The valuation allowance for loan servicing rights with impairments at December 31, 2019 totaled $31 thousand.

The table below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 of the fair value hierarchy:

(dollars in thousands)

Fair Value

Valuation Techniques

Unobservable Input

Range (Weighted Average) (2)

June 30, 2020

Collateral Dependent Impaired Loans

Commercial loans

13,676

Fair value of

Discount for type of property,

0% - 80% (48%)

collateral

age of appraisal, and current status

Commercial real estate loans

21,880

Fair value of

Discount for type of property,

25% - 35% (30%)

collateral

age of appraisal, and current status

Foreclosed Assets

Residential

Fair value of

Discount for type of property,

47% - 98% (73%)

collateral

age of appraisal, and current status

December 31, 2019

Collateral Dependent Impaired Loans

Commercial loans

10,361

Fair value of

Discount for type of property,

0% - 50% (13%)

collateral

age of appraisal, and current status

Commercial real estate loans (1)

11,610

Fair value of

Discount for type of property,

45%

collateral

age of appraisal, and current status

Foreclosed Assets

Commercial real estate (1)

Fair value of

Discount for type of property,

43%

collateral

age of appraisal, and current status

Residential (1)

Fair value of

Discount for type of property,

21%

collateral

age of appraisal, and current status

(1)There was only one collateral dependent impaired commercial real estate loan, one foreclosed commercial real estate asset, and one foreclosed residential asset at December 31, 2019, so no range or weighted average is reported.

(2)Unobservable inputs were weighted by the relative fair value of the instruments.

Fair Value Option

Old National may elect to report most financial instruments and certain other items at fair value on an instrument-by instrument basis with changes in fair value reported in net income. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability, or firm commitment or when certain specified reconsideration events occur. The fair value election may not be revoked once an election is made.

Residential Loans Held For Sale

Old National has elected the fair value option for residential loans held for sale. For these loans, interest income is recorded in the consolidated statements of income based on the contractual amount of interest income earned on the financial assets (except any that are on nonaccrual status). None of these loans are 90 days or more past due, nor are any on nonaccrual status. Included in the income statement is interest income for loans held for sale totaling $0.5 million for the three months ended June 30, 2020 and $0.9 million for the six months ended June 30, 2020, compared to $0.3 million for the three months ended June 30, 2019 and $0.5 million for the six months ended June 30, 2019.

Old National has elected the fair value option for newly originated conforming fixed-rate and adjustable-rate first mortgage loans held for sale. These loans are intended for sale and are hedged with derivative instruments. Old National has elected the fair value option to mitigate accounting mismatches in cases where hedge accounting is complex and to achieve operational simplification. The fair value option was not elected for loans held for investment.

The difference between the aggregate fair value and the aggregate remaining principal balance for loans for which the fair value option has been elected was as follows:


(dollars in thousands)	Aggregate Fair Value		Difference		Contractual Principal
June 30, 2020
Residential loans held for sale	$	122,507	$	6,547	$	115,960
December 31, 2019
Residential loans held for sale	$	46,898	$	1,529	$	45,369

Accrued interest at period end is included in the fair value of the instruments.

The following table presents the amount of gains and losses from fair value changes included in income before income taxes for financial assets carried at fair value:


(dollars in thousands)	Other Gains and (Losses)		Interest Income		Interest (Expense)		Total Changes in Fair Values Included in Current Period Earnings
Three Months Ended June 30, 2020
Residential loans held for sale	$	3,597	$	—	$	(2)	$	3,595

Three Months Ended June 30, 2019
Residential loans held for sale	$	1,085	$	5	$	—	$	1,090

Six Months Ended June 30, 2020
Residential loans held for sale	$	5,018	$	2	$	(2)	$	5,018

Six Months Ended June 30, 2019
Residential loans held for sale	$	1,175	$	10	$	—	$	1,185

Financial Instruments Not Carried at Fair Value

The carrying amounts and estimated fair values of financial instruments not carried at fair value were as follows:


			Fair Value Measurements at June 30, 2020 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Cash, due from banks, money market, and other interest-earning investments	$	310,494	$	310,494	$	—	$	—




Loans, net:
Commercial	4,274,472		—		—		4,249,446
Commercial real estate	5,329,330		—		—		5,255,805
Residential real estate	2,215,054		—		—		2,194,379
Consumer credit	1,668,451		—		—		1,668,203
Accrued interest receivable	84,387		20		27,456		56,911

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	5,217,678	$	5,217,678	$	—	$	—
Checking, NOW, savings, and money market interest-bearing deposits	9,629,535		9,629,535		—		—
Other time deposits	1,321,499		—		1,344,700		—
Brokered certificates of deposit	150,734		—		150,203		—
Federal funds purchased and interbank borrowings	801		801		—		—
Securities sold under agreements to repurchase	367,744		367,744		—		—
FHLB advances	2,035,014		—		2,194,482		—
Other borrowings	237,877		—		256,697		—
Accrued interest payable	6,525		—		6,525		—
Standby letters of credit	420		—		—		420

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	18,402


			Fair Value Measurements at December 31, 2019 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Cash, due from banks, money market, and other interest-earning investments	$	276,337	$	276,337	$	—	$	—




Loans, net:
Commercial	2,867,711		—		—		2,831,298
Commercial real estate	5,145,204		—		—		5,130,848
Residential real estate	2,331,990		—		—		2,357,341
Consumer credit	1,718,000		—		—		1,676,253
Accrued interest receivable	85,123		15		28,185		56,923

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	4,042,286	$	4,042,286	$	—	$	—
Checking, NOW, savings, and money market interest-bearing deposits	8,828,881		8,828,881		—		—
Other time deposits	1,589,988		—		1,600,214		—
Brokered certificates of deposit	92,242		—		92,355		—
Federal funds purchased and interbank borrowings	350,414		350,414		—		—
Securities sold under agreements to repurchase	327,782		327,782		—		—
FHLB advances	1,822,847		—		1,875,089		—
Other borrowings	243,685		—		254,519		—
Accrued interest payable	8,272		—		8,272		—
Standby letters of credit	573		—		—		573

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	4,302

The methods utilized to measure the fair value of financial instruments at June 30, 2020 and December 31, 2019 represent an approximation of exit price, however, an actual exit price may differ.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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