NOTE 20 – FAIR VALUE

FASB ASC 820-10 defines fair value as 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. FASB ASC 820-10 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes 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).

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 December 31, 2017 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Trading securities	$	5,584	$	5,584	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		5,551		5,551		—		—
U.S. government-sponsored entities and agencies		664,286		—		664,286		—
Mortgage-backed securities - Agency		1,667,682		—		1,667,682		—
States and political subdivisions		530,193		—		530,193
Pooled trust preferred securities		8,448		—		—		8,448
Other securities		320,047		30,965		289,082		—
Residential loans held for sale		17,930		—		17,930		—
Derivative assets		14,118		—		14,118		—
Financial Liabilities
Derivative liabilities		16,292		—		16,292		—

			Fair Value Measurements at December 31, 2016 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Trading securities	$	4,982	$	4,982	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		7,103		7,103		—		—
U.S. government-sponsored entities and agencies		493,956		—		493,956		—
Mortgage-backed securities - Agency		1,525,019		—		1,525,019		—
States and political subdivisions		436,684		—		436,684
Pooled trust preferred securities		8,119		—		—		8,119
Other securities		326,293		30,905		295,388		—
Residential loans held for sale		90,682		—		90,682		—
Derivative assets		17,701		—		17,701		—
Financial Liabilities
Derivative liabilities		23,574		—		23,574		—

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


	Years Ended December 31,
(dollars in thousands)	2017			2016
Balance at beginning of period	$	8,119		$	7,900
Accretion of discount		17			18
Sales/payments received		(424	)		(327	)
Increase in fair value of securities		736			528

Balance at end of period	$	8,448		$	8,119

The accretion of discounts on securities in the table above is included in interest income. An increase in fair value is reflected in the balance sheet as an increase in the fair value of investment securities available-for-sale, an increase in accumulated other comprehensive income, which is included in shareholders’ equity, and a decrease in other assets related to the tax impact.

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)
December 31, 2017
Pooled trust preferred securities	$	8,448	Discounted cash flow	Constant prepayment rate (a)	0.00%
				Additional asset defaults (b)	4.2% - 9.6% (7.5%)
				Expected asset recoveries (c)	0.0% - 4.1% (0.6%)
December 31, 2016
Pooled trust preferred securities	$	8,119	Discounted cash flow	Constant prepayment rate (a)	0.00%
				Additional asset defaults (b)	4.5% - 10.0% (7.9%)
				Expected asset recoveries (c)	0.0% - 6.1% (0.9%)

(a)	Assuming no prepayments.

(b)	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%.

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

Significant changes in any of the unobservable inputs used in the fair value measurement in isolation would result 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 has an impact that is directionally opposite from a change in the expected recovery of a defaulted pool asset.

Assets measured at fair value on a non-recurring basis at December 31, 2017 are summarized below:

Fair Value Measurements at December 31, 2017 Using

Significant

Quoted Prices in

Other

Significant

Active Markets for

Observable

Unobservable

Carrying

Identical Assets

Inputs

(dollars in thousands)

Value

(Level 1)

(Level 2)

(Level 3)

Collateral Dependent Impaired Loans:

Commercial loans

2,217

—

2,217

Commercial real estate loans

26,319

—

26,319

Foreclosed Assets:

Commercial real estate

1,726

—

1,726

Residential

—

Loan servicing rights

2,964

—

2,964

—

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 $38.6 million, with a valuation allowance of $10.1 million at December 31, 2017. Old National recorded provision expense associated with these loans totaling $5.2 million in 2017.

Other real estate owned and other repossessed property is measured at fair value less costs to sell and had a net carrying amount of $1.8 million at December 31, 2017. The estimates of fair value 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. There were write-downs of other real estate owned of $2.5 million in 2017.

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 December 31, 2017 totaled $29 thousand. Old National recorded recoveries associated with these loan servicing rights totaling $39 thousand in 2017.

Assets measured at fair value on a non-recurring basis at December 31, 2016 are summarized below:


			Fair Value Measurements at December 31, 2016 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Collateral Dependent Impaired Loans:
Commercial loans	$	6,771	$	—	$	—	$	6,771
Commercial real estate loans		11,632		—		—		11,632
Foreclosed Assets:
Commercial real estate		1,352		—		—		1,352
Residential		394		—		—		394
Loan servicing rights		2,181		—		2,181		—

At December 31, 2016, impaired commercial and commercial real estate loans had a principal amount of $26.4 million, with a valuation allowance of $8.0 million. Old National recorded provision recapture associated with these loans totaling $1.1 million in 2016.

Other real estate owned and other repossessed property had a net carrying amount of $1.7 million at December 31, 2016. There were write-downs of other real estate owned of $3.0 million in 2016.

The valuation allowance for loan servicing rights with impairments at December 31, 2016 totaled $68 thousand. There were impairments associated with these loan servicing rights totaling $34 thousand in 2016.

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

Valuation

Unobservable

Range (Weighted

(dollars in thousands)

Fair Value

Techniques

Input

Average)

December 31, 2017 Collateral Dependent Impaired Loans

Commercial loans

2,217

Fair value of collateral

Discount for type of property, age of appraisal, and current status

0% - 98% (49%)

Commercial real estate loans

26,319

Fair value of collateral

Discount for type of property, age of appraisal and current status

10% -78% (32%)

Foreclosed Assets

Commercial real estate

1,726

Fair value of collateral

Discount for type of property, age of appraisal, and current status

7% - 25% (18%)

Residential (1)

Fair value of collateral

Discount for type of property, age of appraisal, and current status

39%

(1)	There was only one foreclosed residential asset at December 31, 2017, so no range or weighted average rate is reported.

December 31, 2016

Collateral Dependent Impaired Loans

Commercial loans

6,771

Fair value of collateral

Discount for type of property, age of appraisal, and current status

0% - 99% (53%)

Commercial real estate loans

11,632

Fair value of collateral

Discount for type of property, age of appraisal, and current status

10% - 67% (36%)

Foreclosed Assets

Commercial real estate

1,352

Fair value of collateral

Discount for type of property, age of appraisal, and current status

4% - 80% (39%)

Residential

394

Fair value of collateral

Discount for type of property, age of appraisal, and current status

7% - 60% (30%)

Financial instruments recorded using fair value option

Under FASB ASC 825-10, we 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.

We have 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 $0.2 million in 2017 and $0.1 million in 2016.

Residential loans held for sale

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 as of December 31, 2017 and 2016 was as follows:


	Aggregate				Contractual
(dollars in thousands)	Fair Value		Difference		Principal
December 31, 2017
Residential loans held for sale	$	17,930	$	546	$	17,384

December 31, 2016
Residential loans held for sale	$	90,682	$	133	$	90,549

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 for the years ended December 31:


								Total Changes
								in Fair Values
	Other							Included in
	Gains and			Interest		Interest		Current Period
(dollars in thousands)	(Losses)			Income		(Expense)		Earnings
Year Ended December 31, 2017
Residential loans held for sale	$	409		$	4	$	—	$	413

Year Ended December 31, 2016
Residential loans held for sale	$	(103	)	$	—	$	—	$	(103	)

The carrying amounts and estimated fair values of financial instruments, not previously presented in this note, at December 31, 2017 and 2016 were as follows:

Fair Value Measurements at December 31, 2017 Using

Significant

Quoted Prices in

Other

Significant

Active Markets for

Observable

Unobservable

Carrying

Identical Assets

Inputs

(dollars in thousands)

Value

(Level 1)

(Level 2)

(Level 3)

Financial Assets

Cash, due from banks, money market, and other interest-earning investments

290,432

—

Investment securities held-to-maturity:

Mortgage-backed securities—Agency

6,903

—

7,056

—

State and political subdivisions

677,160

—

720,647

—

FHLB/Federal Reserve Bank stock

119,686

N/A

Loans, net:

Commercial

2,698,023

—

2,707,385

Commercial real estate

4,333,116

—

4,347,949

Residential real estate

2,165,290

—

2,210,951

Consumer credit

1,871,311

—

1,998,194

Accrued interest receivable

87,102

24,001

63,085

Financial Liabilities

Deposits:

Noninterest-bearing demand deposits

3,680,807

—

NOW, savings, and money market deposits

7,290,521

—

Time deposits

1,634,436

—

1,620,685

—

Federal funds purchased and interbank borrowings

335,033

—

Securities sold under agreements to repurchase

384,810

359,810

25,133

—

FHLB advances

1,609,579

—

1,607,189

Other borrowings

248,782

—

250,443

—

Accrued interest payable

7,029

—

7,029

—

Standby letters of credit

351

—

351

Off-Balance Sheet Financial Instruments

Commitments to extend credit

—

2,449

N/A = not applicable


			Fair Value Measurements at December 31, 2016 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	$	255,519	$	255,519	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		40,131		—		40,558		—
Mortgage-backed securities - Agency		10,640		—		10,940		—
State and political subdivisions		694,319		—		732,674		—
FHLB/Federal Reserve Bank stock		101,716		N/A		N/A		N/A
Loans, net:
Commercial		1,895,618		—		—		1,971,296
Commercial real estate		3,112,680		—		—		3,400,365
Residential real estate		2,085,887		—		—		2,228,542
Consumer credit		1,866,519		—		—		1,974,180
Accrued interest receivable		81,381		16		22,880		58,485
Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	3,016,093	$	3,016,093	$	—	$	—
NOW, savings, and money market deposits		6,259,052		6,259,052		—		—
Time deposits		1,468,108		—		1,460,778		—
Federal funds purchased and interbank borrowings		213,003		213,003		—		—
Securities sold under agreements to repurchase		367,052		317,052		50,612		—
FHLB advances		1,353,092		—		—		1,360,599
Other borrowings		218,939		—		217,647		—
Accrued interest payable		5,979		—		5,979		—
Standby letters of credit		315		—		—		315
Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	2,527

N/A = not applicable

The following methods and assumptions were used to estimate the fair value of each type of financial instrument.

Cash, due from banks, federal funds sold, and money market investments: For these instruments, the carrying amounts approximate fair value (Level 1).

Investment securities: Fair values for investment securities held-to-maturity are based on quoted market prices, if available. For securities where quoted prices are not available, fair values are estimated based on market prices of similar securities (Level 2).

FHLB and Federal Reserve Bank stock: Old National Bank is a member of the FHLB and the Federal Reserve System. The carrying value is our basis because it is not practical to determine the fair value due to restrictions placed on transferability.

Loans: The fair value of loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities (Level 3). The method utilized to estimate the fair value of loans does not necessarily represent an exit price.

Accrued interest receivable and payable: The carrying amount approximates fair value and is aligned with the underlying assets or liabilities (Level 1, Level 2, or Level 3).

Deposits: The fair value of noninterest-bearing demand deposits and savings, NOW, and money market deposits is the amount payable as of the reporting date (Level 1). The fair value of fixed-maturity certificates of deposit is estimated using rates currently offered for deposits with similar remaining maturities (Level 2).

Federal funds purchased and interbank borrowings: Federal funds purchased and interbank borrowings generally have an original term to maturity of 30 days or less and, therefore, their carrying amount is a reasonable estimate of fair value (Level 1).

Securities sold under agreements to repurchase: The fair value of securities sold under agreements to repurchase is determined using end of day market prices (Level 1 or Level 2).

Federal Home Loan Bank advances: The fair value of FHLB advances is determined using calculated prices for new FHLB advances with similar risk characteristics (Level 3).

Other borrowings: The fair value of medium-term notes, subordinated debt, and senior bank notes is determined using market quotes (Level 2). The fair value of other debt is determined using comparable security market prices or dealer quotes (Level 2).

Standby letters of credit: Fair values for standby letters of credit are based on fees currently charged to enter into similar agreements. The fair value for standby letters of credit was recorded in “Accrued expenses and other liabilities” on the consolidated balance sheet in accordance with FASB ASC 460-10 (FIN 45) (Level 3).

Off-balance sheet financial instruments: Fair values for off-balance sheet credit-related financial instruments are based on fees currently charged to enter into similar agreements (Level 3). For further information regarding the amounts of these financial instruments, see Notes 22 and 23.