NOTE 25 – 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 June 30, 2018 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
Trading securities	$	5,596	$	5,596	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		5,257		5,257		—		—
U.S. government-sponsored entities and agencies		568,231		—		568,231		—
Mortgage-backed securities - Agency		1,448,526		—		1,448,526		—
States and political subdivisions		797,533		—		793,505		4,028
Pooled trust preferred securities		8,205		—		—		8,205
Other securities		353,913		30,259		323,654		—
Residential loans held for sale		26,198		—		26,198		—
Derivative assets		14,993		—		14,993		—
Financial Liabilities
Derivative liabilities		21,196		—		21,196		—

			Fair Value Measurements at December 31, 2017 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
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		—

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
Six Months Ended June 30, 2018
Balance at beginning of period	$	8,448		$	—
Accretion (amortization) of discount		10			(18	)
Sales/payments received		(305	)		—
Increase (decrease) in fair value of securities		52			(15	)
Transfers into Level 3		—			4,061

Balance at end of period	$	8,205		$	4,028

Six Months Ended June 30, 2017
Balance at beginning of period	$	8,119		$	—
Accretion of discount		8			—
Sales/payments received		(212	)		—
Increase (decrease) in fair value of securities		182			—

Balance at end of period	$	8,097		$	—

The accretion or amortization 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. 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. Old National transferred a $4.1 million state and political subdivisions security to Level 3 during the six months ended June 30, 2018 because Old National could no longer obtain evidence of observable inputs.

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)

June 30, 2018

Pooled trust preferred securities

8,205

Discounted cash flow

Constant prepayment rate (a)

0.00%

Additional asset defaults (b)

3.4% - 4.4% (4.1%)

Expected asset recoveries (c)

0.00%

State and political subdivisions

4,028

Discounted cash flow

No observable inputs

Local municipality issuance Old National owns 100% Carried at par

N/A

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%)

(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 June 30, 2018 are summarized below:

Fair Value Measurements at June 30, 2018 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

4,000

—

4,000

Commercial real estate loans

20,375

—

20,375

Foreclosed Assets:

Commercial real estate

762

—

762

Loan servicing rights

158

—

158

—

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 $37.1 million, with a valuation allowance of $12.7 million at June 30, 2018. Old National recorded provision expense associated with these loans totaling $4.9 million for the three months ended June 30, 2018 and $6.5 million for the six months ended June 30, 2018. Old National recorded provision expense associated with impaired commercial and commercial real estate loans that were deemed collateral dependent totaling $5.1 million for the three months ended June 30, 2017 and $6.2 million for the six months ended June 30, 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 $0.8 million at June 30, 2018. 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 $0.1 million for the three months ended June 30, 2018 and $0.4 million for the six months ended June 30, 2018. There were write-downs of other real estate owned of $0.8 million for the three months ended June 30, 2017 and $1.6 million for the six months ended June 30, 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 June 30, 2018 totaled $15 thousand. Old National recorded recoveries associated with these loan servicing rights totaling $4 thousand for the three months ended June 30, 2018 and $14 thousand for the six months ended June 30, 2018. There were impairments of loan servicing rights totaling $25 thousand for the three months ended June 30, 2017 and $7 thousand for the six months ended June 30, 2017.

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
(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	$	2,217	$	—	$	—	$	2,217
Commercial real estate loans		26,319		—		—		26,319
Foreclosed Assets:
Commercial real estate		1,726		—		—		1,726
Residential		55		—		—		55
Loan servicing rights		2,964		—		2,964		—

At December 31, 2017, impaired commercial and commercial real estate loans had a principal amount of $38.6 million, with a valuation allowance of $10.1 million.

Other real estate owned and other repossessed property had a net carrying amount of $1.8 million at December 31, 2017.

The valuation allowance for loan servicing rights with impairments at December 31, 2017 totaled $29 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)

June 30, 2018

Collateral Dependent Impaired Loans

Commercial loans

4,000

Fair value of collateral

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

25% - 35% (30%)

Commercial real estate loans

20,375

Fair value of collateral

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

0% - 20% (10%)

Foreclosed Assets

Commercial real estate

762

Fair value of collateral

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

8% - 41% (21%)

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.

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 $40 thousand for the three months ended June 30, 2018 and $62 thousand for the six months ended June 30, 2018. Included in the income statement is interest income for loans held for sale totaling $41 thousand for the three months ended June 30, 2017 and $69 thousand for the six months ended June 30, 2017.

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 at June 30, 2018 and December 31, 2017 was as follows:


(dollars in thousands)	Aggregate Fair Value		Difference		Contractual Principal
June 30, 2018
Residential loans held for sale	$	26,198	$	967	$	25,231

December 31, 2017
Residential loans held for sale	$	17,930	$	546	$	17,384

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, 2018
Residential loans held for sale	$	387	$	3	$	—		$	390

Three Months Ended June 30, 2017
Residential loans held for sale	$	279	$	1	$	—		$	280

Six Months Ended June 30, 2018
Residential loans held for sale	$	422	$	3	$	(4	)	$	421

Six Months Ended June 30, 2017
Residential loans held for sale	$	697	$	2	$	—		$	699

The carrying amounts and estimated fair values of financial instruments not carried at fair value on the balance sheet at June 30, 2018 and December 31, 2017 were as follows:


			Fair Value Measurements at June 30, 2018 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	$	273,874	$	273,874	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		73,570		—		71,284		—
Mortgage-backed securities - Agency		139,594		—		135,784		—
State and political subdivisions		312,554		—		317,529		—
FHLB/Federal Reserve Bank stock		136,206		N/A		N/A		N/A
Loans, net:
Commercial		2,941,508		—		—		2,845,502
Commercial real estate		4,429,274		—		—		4,330,899
Residential real estate		2,152,106		—		—		2,117,999
Consumer credit		1,719,081		—		—		1,669,906
Accrued interest receivable		81,290		13		23,122		58,155

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	3,600,793	$	3,600,793	$	—	$	—
Checking, NOW, savings, and money market interest-bearing deposits		7,171,033		7,171,033		—		—
Time deposits		1,824,550		—		1,822,203		—
Federal funds purchased and interbank borrowings		175,044		175,044		—		—
Securities sold under agreements to repurchase		347,511		347,511		—		—
FHLB advances		1,757,308		—		—		1,747,022
Other borrowings		250,241		—		249,150		—
Accrued interest payable		7,510		—		7,510		—
Standby letters of credit		397		—		—		397

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	3,847

N/A	= not applicable


			Fair Value Measurements at December 31, 2017 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	$	290,432	$	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		N/A		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		16		24,001		63,085

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	3,680,807	$	3,680,807	$	—	$	—
Checking, NOW, savings, and money market interest-bearing deposits		7,290,521		7,290,521		—		—
Time deposits		1,634,436		—		1,620,685		—
Federal funds purchased and interbank borrowings		335,033		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

The methods utilized to estimate the fair value of financial instruments at December 31, 2017 did not necessarily represent an exit price. In accordance with our adoption of ASU 2016-01 in 2018, the methods utilized to measure the fair value of financial instruments at June 30, 2018 represent an approximation of exit price, however, an actual exit price may differ.