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:

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 September 30, 2018 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	$	5,828	$	5,828	$	-	$	-
Investment securities available-for-sale:
U.S. Treasury		5,237		5,237		-		-
U.S. government-sponsored entities and agencies		611,696		-		611,696		-
Mortgage-backed securities - Agency		1,508,692		-		1,508,692		-
States and political subdivisions		792,666		-		788,687		3,979
Pooled trust preferred securities		9,072		-		-		9,072
Other securities		345,093		30,026		315,067		-
Residential loans held for sale		21,384		-		21,384		-
Derivative assets		16,530		-		16,530		-
Financial Liabilities
Derivative liabilities		24,304		-		24,304		-

			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		-

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

	Pooled Trust			States and
	Preferred			Political
(dollars in thousands)	Securities			Subdivisions
Three Months Ended September 30, 2018
Balance at beginning of period	$	8,205		$	4,028
Accretion (amortization) of discount		3			(19	)
Sales/payments received		(17	)		-
Increase (decrease) in fair value of securities		881			(30	)
Balance at end of period	$	9,072		$	3,979

Three Months Ended September 30, 2017
Balance at beginning of period	$	8,097		$	-
Accretion of discount		5			-
Sales/payments received		(161	)		-
Increase (decrease) in fair value of securities		329			-
Balance at end of period	$	8,270		$	-

Nine Months Ended September 30, 2018
Balance at beginning of period	$	8,448		$	-
Accretion (amortization) of discount		13			(37	)
Sales/payments received		(322	)		-
Increase (decrease) in fair value of securities		933			(45	)
Transfers into Level 3		-			4,061
Balance at end of period	$	9,072		$	3,979

Nine Months Ended September 30, 2017
Balance at beginning of period	$	8,119		$	-
Accretion of discount		13			-
Sales/payments received		(373	)		-
Increase (decrease) in fair value of securities		511			-
Balance at end of period	$	8,270		$	-

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 nine months ended September 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:

Valuation

Unobservable

Range (Weighted

(dollars in thousands)

Fair Value

Techniques

Input

Average)

September 30, 2018

Pooled trust preferred securities

9,072

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

3,979

Discounted cash flow

No observable inputs

N/A

Local municipality issuance

Old National owns 100%

Carried at par

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%)

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 September 30, 2018 are summarized below:

			Fair Value Measurements at September 30, 2018 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	$	8,555	$	-	$	-	$	8,555
Commercial real estate loans		29,099		-		-		29,099
Foreclosed Assets:
Commercial real estate		543		-		-		543
Residential		151		-		-		151
Loan servicing rights		110		-		110		-

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 $48.2 million, with a valuation allowance of $10.6 million at September 30, 2018. Old National recorded provision expense associated with these loans totaling $1.2 million for the three months ended September 30, 2018 and $7.7 million for the nine months ended September 30, 2018. Old National recorded provision recapture associated with impaired commercial and commercial real estate loans that were deemed collateral dependent totaling $0.8 million for the three months ended September 30, 2017 and provision expense of $5.4 million for the nine months ended September 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 $0.7 million at September 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 September 30, 2018 and $0.5 million for the nine months ended September 30, 2018. There were write-downs of other real estate owned of $0.3 million for the three months ended September 30, 2017 and $2.0 million for the nine months ended September 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 September 30, 2018 totaled $12 thousand. Old National recorded recoveries associated with these loan servicing rights totaling $3 thousand for the three months ended September 30, 2018 and $17 thousand for the nine months ended September 30, 2018. There were recoveries of loan servicing rights totaling $21 thousand for the three months ended September 30, 2017 and $14 thousand for the nine months ended September 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
					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	$	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:

Valuation

Unobservable

Range (Weighted

(dollars in thousands)

Fair Value

Techniques

Input

Average)

September 30, 2018

Collateral Dependent Impaired

Loans

Commercial loans

8,555

Fair value of

Discount for type of property,

25% - 90% (43%)

collateral

age of appraisal, and current

status

Commercial real estate loans

29,099

Fair value of

Discount for type of property,

0% - 50% (30%)

collateral

age of appraisal and current

status

Foreclosed Assets

Commercial real estate (1)

543

Fair value of

Discount for type of property,

12%

collateral

age of appraisal, and current

status

Residential (1)

151

Fair value of

Discount for type of property,

collateral

age of appraisal, and current status

(1) There was only one commercial real estate asset and one foreclosed residential asset at September 30, 2018, so no range or weighted average rate is reported.

December 31, 2017

Collateral Dependent Impaired

Loans

Commercial loans

2,217

Fair value of

Discount for type of property,

0% - 98% (49%)

collateral

age of appraisal, and current

status

Commercial real estate loans

26,319

Fair value of

Discount for type of property,

10% - 78% (32%)

collateral

age of appraisal and current

status

Foreclosed Assets

Commercial real estate

1,726

Fair value of

Discount for type of property,

7% - 25% (18%)

collateral

age of appraisal, and current

status

Residential (2)

Fair value of

Discount for type of property,

39%

collateral

age of appraisal, and current status

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 for the three months ended September 30, 2018 and $0.3 million for the nine months ended September 30, 2018. Included in the income statement is interest income for loans held for sale totaling $56 thousand for the three months ended September 30, 2017 and $0.1 million for the nine months ended September 30, 2017.

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 September 30, 2018 and December 31, 2017 was as follows:

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:

									Total Changes
									in Fair Values
	Other								Included in
	Gains and			Interest		Interest			Current Period
(dollars in thousands)	(Losses)			Income		(Expense)			Earnings
Three Months Ended September 30, 2018
Residential loans held for sale	$	(368	)	$	3	$	-		$	(365	)

Three Months Ended September 30, 2017
Residential loans held for sale	$	58		$	-	$	-		$	58

Nine Months Ended September 30, 2018
Residential loans held for sale	$	54		$	6	$	(4	)	$	56

Nine Months Ended September 30, 2017
Residential loans held for sale	$	755		$	2	$	-		$	757

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

			Fair Value Measurements at September 30, 2018 Using
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Cash, due from banks, money market, and other interest-earning investments	$	286,761	$	286,761	$	-	$	-
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		73,776		-		70,632		-
Mortgage-backed securities - Agency		131,562		-		126,612		-
State and political subdivisions		306,869		-		308,322		-
FHLB/Federal Reserve Bank stock		136,206	N/A		N/A		N/A
Loans, net:
Commercial		2,929,558		-		-		2,871,624
Commercial real estate		4,458,662		-		-		4,374,201
Residential real estate		2,164,283		-		-		2,117,866
Consumer credit		1,687,443		-		-		1,646,883
Accrued interest receivable		78,493		34		21,556		56,903

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	3,588,370	$	3,588,370	$	-	$	-
Checking, NOW, savings, and money market interest-bearing deposits		7,117,695		7,117,695		-		-
Time deposits		1,892,135		-		1,889,488		-
Federal funds purchased and interbank borrowings		450,031		450,031		-		-
Securities sold under agreements to repurchase		319,831		319,831		-		-
FHLB advances		1,554,515		-		-		1,540,755
Other borrowings		251,662		-		248,749		-
Accrued interest payable		6,582		-		6,582		-
Standby letters of credit		445		-		-		445

Off-Balance Sheet Financial
Instruments
Commitments to extend credit	$	-	$	-	$	-	$	3,209
N/A = not applicable

			Fair Value Measurements at December 31, 2017 Using
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		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	$	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 September 30, 2018 represent an approximation of exit price, however, an actual exit price may differ.