Note 5. Fair Value Measurement of Assets and Liabilities

ASC Topic 820, “Fair Value Measurements and Disclosures,” 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 are described below:


Level 1		Unadjusted exchange quoted prices in active markets for identical assets or liabilities, or identical liabilities traded as assets that the reporting entity has the ability to access at the measurement date.

Level 2		Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly (i.e., quoted prices on similar assets), for substantially the full term of the asset or liability.

Level 3		Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).

Assets and Liabilities Measured at Fair Value on a Recurring and Non-recurring Basis

The following tables present the assets and liabilities that are measured at fair value on a recurring and nonrecurring basis by level within the fair value hierarchy as reported on the consolidated statements of financial condition at June 30, 2013 and December 31, 2012. The assets presented under “nonrecurring fair value measurements” in the table below are not measured at fair value on an ongoing basis but are subject to fair value adjustments under certain circumstances (e.g., when an impairment loss is recognized).


			Fair Value Measurements at Reporting Date Using:
	June 30, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Recurring fair value measurements:
Assets
Investment securities:
Available for sale:
U.S. Treasury securities	$	89,786	$	89,786	$	—	$	—
U.S. government agency securities		55,808		—		55,808		—
Obligations of states and political subdivisions		39,234		—		39,234		—
Residential mortgage-backed securities		573,827		—		545,687		28,140
Trust preferred securities		68,413		—		17,441		50,972
Corporate and other debt securities		84,246		26,721		57,525		—
Equity securities		47,342		26,675		20,667		—

Total available for sale		958,656		143,182		736,362		79,112
Trading securities		14,170		—		14,170
Loans held for sale ⁽¹⁾		48,901		—		48,901		—
Other assets ⁽²⁾		7,425		—		7,425		—

Total assets	$	1,029,152	$	143,182	$	806,858	$	79,112


Liabilities
Junior subordinated debentures issued to VNB Capital Trust I ⁽³⁾	$	150,001	$	150,001	$	—	$	—
Other liabilities ⁽²⁾		18,971		—		18,971		—

Total liabilities	$	168,972	$	150,001	$	18,971	$	—


Non-recurring fair value measurements:
Collateral dependent impaired loans ⁽⁴⁾		41,835		—		—		41,835
Loan servicing rights		5,558		—		—		5,558
Foreclosed assets		7,192		—		—		7,192

Total	$	54,585	$	—	$	—	$	54,585


			Fair Value Measurements at Reporting Date Using:
	December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Recurring fair value measurements:
Assets
Investment securities:
Available for sale:
U.S. Treasury securities	$	97,625	$	97,625	$	—	$	—
U.S. government agency securities		45,762		—		45,762		—
Obligations of states and political subdivisions		16,627		—		16,627		—
Residential mortgage-backed securities		510,154		—		478,783		31,371
Trust preferred securities		57,432		—		17,129		40,303
Corporate and other debt securities		30,708		28,444		2,264		—
Equity securities		49,508		28,608		20,900		—

Total available for sale		807,816		154,677		581,465		71,674
Trading securities		22,157		—		22,157		—
Loans held for sale ⁽¹⁾		120,230		—		120,230		—
Other assets ⁽²⁾		7,916		—		7,916		—

Total assets	$	958,119	$	154,677	$	731,768	$	71,674


Liabilities
Junior subordinated debentures issued to VNB Capital Trust I⁽³⁾	$	147,595	$	147,595	$	—	$	—
Other liabilities⁽²⁾		26,594		—		26,594		—

Total liabilities	$	174,189	$	147,595	$	26,594	$	—


Non-recurring fair value measurements:
Collateral dependent impaired loans ⁽⁴⁾	$	65,231	$	—	$	—	$	65,231
Loan servicing rights		16,201		—		—		16,201
Foreclosed assets		33,251		—		—		33,251

Total	$	114,683	$	—	$	—	$	114,683

⁽¹⁾	Loans held for sale (which consist of residential mortgages) are carried at fair value and had contractual unpaid principal balances totaling approximately $49.1 million and $115.4 million at June 30, 2013 and December 31, 2012, respectively.

⁽²⁾	Derivative financial instruments are included in this category.

⁽³⁾	The junior subordinated debentures had contractual unpaid principal obligations totaling $146.7 million at June 30, 2013 and December 31, 2012.

⁽⁴⁾	Excludes covered loans acquired in the FDIC-assisted transactions and other purchased credit-impaired loans acquired in the first quarter of 2012.

The changes in Level 3 assets measured at fair value on a recurring basis for the three and six months ended June 30, 2013 and 2012 are summarized below:


	Available for Sale Securities
	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2013			2012			2013			2012
	(in thousands)
Balance, beginning of the period	$	77,920		$	84,720		$	71,674		$	77,311
Total net gains (losses) for the period included in:
Net income		—			(550	)		—			(550	)
Other comprehensive income		3,406			7,847			11,439			18,954
Settlements		(2,214	)		(2,926	)		(4,001	)		(6,624	)

Balance, end of the period	$	79,112		$	89,091		$	79,112		$	89,091


Change in unrealized losses for the period included in earnings for assets held at the end of the reporting period *	$	—		$	(550	)	$	—		$	(550	)

*	Represents the net impairment losses on securities recognized in earnings for the period.

During the three and six months ended June 30, 2013 and 2012, there were no transfers of assets between Level 1 and Level 2.

There have been no material changes in the valuation methodologies used at June 30, 2013 from December 31, 2012.

The following valuation techniques were used for financial instruments measured at fair value on a recurring basis. All the valuation techniques described below apply to the unpaid principal balance excluding any accrued interest or dividends at the measurement date. Interest income and expense are recorded within the consolidated statements of income depending on the nature of the instrument using the effective interest method based on acquired discount or premium.

Available for sale and trading securities. All U.S. Treasury securities, certain corporate and other debt securities, and certain common and preferred equity securities (including certain trust preferred securities) are reported at fair values utilizing Level 1 inputs. The majority of other investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participants with whom Valley has historically transacted both purchases and sales of investment securities. Prices obtained from these sources include prices derived from market quotations and matrix pricing. 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. Management reviews the data and assumptions used in pricing the securities by its third party provider to ensure the highest level of significant inputs are derived from market observable data. For certain securities, the inputs used by either dealer market participants or an independent pricing service, may be derived from unobservable market information (Level 3 inputs). In these instances, Valley evaluates the appropriateness and quality of the assumption and the resulting price. In addition, Valley reviews the volume and level of activity for all available for sale and trading securities and attempts to identify transactions which may not be orderly or reflective of a significant level of activity and volume. For securities meeting these criteria, the quoted prices received from either market participants or an independent pricing service may be adjusted, as necessary, to estimate fair value and this results in fair values based on Level 3 inputs. In determining fair value, Valley utilizes unobservable inputs which reflect Valley’s own assumptions about the inputs that market participants would use in pricing each security. In developing its assertion of market participant assumptions, Valley utilizes the best information that is both reasonable and available without undue cost and effort.

In calculating the fair value for the available for sale securities under Level 3, Valley prepared present value cash flow models for certain private label mortgage-backed securities and trust preferred securities. The cash flows for the residential mortgage-backed securities incorporated the expected cash flow of each security adjusted for default rates, loss severities and prepayments of the individual loans collateralizing the security. The cash flows for trust preferred securities reflected the contractual cash flow, adjusted if necessary for potential changes in the amount or timing of cash flows due to the underlying credit worthiness of each issuer.

The following table presents quantitative information about Level 3 inputs used to measure the fair value of these securities at June 30, 2013:


Security Type	Valuation Technique	Unobservable Input	Range			Weighted Average

Private label mortgage-backed securities	Discounted cash flow	Prepayment rate		14.7 - 25.2	%		19.3	%
		Default rate		4.3 - 12.2			7.0
		Loss severity		40.2 - 59.8			51.4

Single issuer trust preferred securities	Discounted cash flow	Loss severity		0.0 - 100.0	%		20.3	%
		Market credit spreads		4.8 - 5.4			5.2
		Discount rate		5.1 - 7.9			6.7

Significant increases or decreases in any of the unobservable inputs in the table above in isolation would result in a significantly lower or higher fair value measurement of the securities. Generally, a change in the assumption used for the default rate is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

For the Level 3 available for sale private label mortgage-backed securities, cash flow assumptions incorporated independent third party market participant data based on vintage year for each security. The discount rate utilized in determining the present value of cash flows for the mortgage-backed securities was arrived at by combining the yield on orderly transactions for similar maturity government sponsored mortgage-backed securities with (i) the historical average risk premium of similar structured private label securities, (ii) a risk premium reflecting current market conditions, including liquidity risk and (iii) if applicable, a forecasted loss premium derived from the expected cash flows of each security. The estimated cash flows for each private label mortgage-backed security were then discounted at the aforementioned effective rate to determine the fair value. The quoted prices received from either market participants or independent pricing services are weighted with the internal price estimate to determine the fair value of each instrument.

For two single issuer trust preferred securities in the Level 3 available for sale trust preferred securities, the resulting estimated future cash flows were discounted at a yield, comprised of market rates applicable to the index of the underlying security, estimated market credit spread for similar non-rated securities and an illiquidity premium, if appropriate. The discount rate for each security was applied to three alternative cash flow scenarios, and subsequently weighted based on management’s expectations. The three cash flow alternatives for each security assume a scenario with full issuer repayment, a scenario with a partial issuer repayment and a scenario with a full issuer default.

For two pooled securities in the Level 3 available for sale trust preferred securities category, the resulting estimated future cash flows were discounted at a yield determined by reference to similarly structured securities for which observable orderly transactions occurred. The discount rate for each security was applied using a pricing matrix based on credit, security type and maturity characteristics to determine the fair value. The fair value calculations for both securities are received from an independent valuation advisor. In validating the fair value calculation from an independent valuation advisor, Valley reviews the accuracy of the inputs and the appropriateness of the unobservable inputs utilized in the valuation to ensure the fair value calculation is reasonable from a market participant perspective.

Loans held for sale. The conforming residential mortgage loans originated for sale are reported at fair value using Level 2 inputs. The fair values were calculated utilizing quoted prices for similar assets in active markets. To determine these fair values, the mortgages held for sale are put into multiple tranches, or pools, based on the coupon rate and maturity of each mortgage. The market prices for each tranche are obtained from both Fannie Mae and Freddie Mac. The market prices represent a delivery price, which reflects the underlying price each institution would pay Valley for an immediate sale of an aggregate pool of mortgages. The market prices received from Fannie Mae and Freddie Mac are then averaged and interpolated or extrapolated, where required, to calculate the fair value of each tranche. Depending upon the time elapsed since the origination of each loan held for sale, non-performance risk and changes therein were addressed in the estimate of fair value based upon the delinquency data provided to both Fannie Mae and Freddie Mac for market pricing and changes in market credit spreads. Non-performance risk did not materially impact the fair value of mortgage loans held for sale at June 30, 2013 and December 31, 2012 based on the short duration these assets were held, and the high credit quality of these loans.

Junior subordinated debentures issued to capital trusts. The junior subordinated debentures issued to VNB Capital Trust I are reported at fair value using Level 1 inputs. The fair value was estimated using quoted prices in active markets for similar assets, specifically the quoted price of the VNB Capital Trust I preferred stock traded under ticker symbol “VLYPRA” on the New York Stock Exchange. The preferred stock and Valley’s junior subordinated debentures issued to the Trust have identical financial terms and therefore, the preferred stock’s quoted price moves in a similar manner to the estimated fair value and current settlement price of the junior subordinated debentures. The preferred stock’s quoted price includes market considerations for Valley’s credit and non-performance risk and is deemed to represent the transfer price that would be used if the junior subordinated debenture were assumed by a third party. Valley’s potential credit risk did not materially impact the fair value measurement of the junior subordinated debentures at June 30, 2013 and December 31, 2012.

Derivatives. Derivatives are reported at fair value utilizing Level 2 inputs. The fair value of Valley’s derivatives are determined using third party prices that are based on discounted cash flows analyses using observed market inputs, such as the LIBOR and Overnight Index Swap rate curves. The fair value of mortgage banking derivatives, consisting of interest rate lock commitments to fund residential mortgage loans and forward commitments for the future delivery of such loans (including certain loans held for sale at June 30, 2013), is determined based on the current market prices for similar instruments provided by Freddie Mac and Fannie Mae. The fair values of most of the derivatives incorporate credit valuation adjustments, which consider the impact of any credit enhancements to the contracts, to account for potential nonperformance risk of Valley and its counterparties. The credit valuation adjustments were not significant to the overall valuation of Valley’s derivatives at June 30, 2013 and December 31, 2012.

Assets and Liabilities Measured at Fair Value on a Non-recurring Basis

The following valuation techniques were used for certain non-financial assets measured at fair value on a nonrecurring basis, including impaired loans reported at the fair value of the underlying collateral, loan servicing rights, other real estate owned and other repossessed assets (upon initial recognition or subsequent impairment) as described below.

Impaired loans. Certain impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral and are commonly referred to as “collateral dependent impaired loans.” Collateral values are estimated using Level 3 inputs, consisting of individual appraisals that are significantly adjusted based on customized discounting criteria. At June 30, 2013, non-current appraisals were discounted up to 13.8 percent based on specific market data by location and property type. During the quarter ended June 30, 2013, collateral dependent impaired loans were individually re-measured and reported at fair value through direct loan charge-offs to the allowance for loan losses and/or a specific valuation allowance allocation based on the fair value of the underlying collateral. The collateral dependent loan charge-offs to the allowance for loan losses totaled $5.2 million and $13.4 million for the three and six months ended June 30, 2013, respectively. At June 30, 2013, collateral dependent impaired loans with a total recorded investment of $49.5 million were reduced by specific valuation allowance allocations totaling $7.7 million to a reported total net carrying amount of $41.8 million.

Loan servicing rights. Fair values for each risk-stratified group of loan servicing rights are calculated using a fair value model from a third party vendor that requires inputs that are both significant to the fair value measurement and unobservable (Level 3). The fair value model is based on various assumptions, including but not limited to, prepayment speeds, internal rate of return (“discount rate”), servicing cost, ancillary income, float rate, tax rate, and inflation. The prepayment speed and the discount rate are considered two of the most significant inputs in the model. At June 30, 2013, the fair value model used prepayment speeds (stated as constant prepayment rates) from 6 percent up to 24 percent and a discount rate of 8 percent for the valuation of the loan servicing rights. A significant degree of judgment is involved in valuing the loan servicing rights using Level 3 inputs. The use of different assumptions could have a significant positive or negative effect on the fair value estimate. Impairment charges are recognized on loan servicing rights when the amortized cost of a risk-stratified group of loan servicing rights exceeds the estimated fair value. Valley recognized net recoveries of impairment charges totaling $759 thousand and $2.1 million for the three and six months ended June 30, 2013, respectively.

Foreclosed assets. Certain foreclosed assets (consisting of other real estate owned and other repossessed assets), upon initial recognition and transfer from loans, are re-measured and reported at fair value through a charge-off to the allowance for loan losses based upon the fair value of the foreclosed assets. The fair value of a foreclosed asset, upon initial recognition, is typically estimated using Level 3 inputs, consisting of an appraisal that is adjusted based on customized discounting criteria, similar to the criteria used for impaired loans described above. The discounts on appraisals of foreclosed assets were immaterial at June 30, 2013. At June 30, 2013, foreclosed assets included $7.2 million of assets that were measured at fair value upon initial recognition or subsequently re-measured during the quarter ended June 30, 2013. The foreclosed assets charge-offs to the allowance for loan losses totaled $1.6 million and $3.1 million for the three and six months ended June 30, 2013, respectively. The re-measurement of repossessed assets at fair value subsequent to their initial recognition resulted in a loss of $570 thousand within non-interest expense for the six months ended June 30, 2013.

Other Fair Value Disclosures

The following table presents the amount of gains and losses from fair value changes included in income before income taxes for financial assets and liabilities carried at fair value for the three and six months ended June 30, 2013 and 2012:


		Gains (Losses) on Change in Fair Value
Reported in Consolidated Statements of Financial Condition	Reported in Consolidated Statements of Income	Three Months Ended June 30,						Six Months Ended June 30,
	Reported in Consolidated Statements of Income	2013			2012			2013			2012
		(in thousands)
Assets:
Available for sale securities	Net impairment losses on securities	$	—		$	(550	)	$	—		$	(550	)
Trading securities	Trading (losses) gains, net		(36	)		(151	)		(66	)		101
Loans held for sale	Gains on sales of loans, net		14,366			3,141			29,426			6,307
Liabilities:
Junior subordinated debentures issued to capital trusts	Trading (losses) gains, net		(234	)		1,760			(2,406	)		520

		$	14,096		$	4,200		$	26,954		$	6,378

ASC Topic 825, “Financial Instruments,” requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.

The fair value estimates presented in the following table were based on pertinent market data and relevant information on the financial instruments available as of the valuation date. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire portfolio of financial instruments. Because no market exists for a portion of the financial instruments, fair value estimates may be based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For instance, Valley has certain fee-generating business lines (e.g., its mortgage servicing operation, trust and investment management departments) that were not considered in these estimates since these activities are not financial instruments. In addition, the tax implications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.

The carrying amounts and estimated fair values of financial instruments not measured and not reported at fair value on the consolidated statements of financial condition at June 30, 2013 and December 31, 2012 were as follows:


		June 30, 2013				December 31, 2012
	Fair Value Hierarchy	Carrying Amount		Fair Value		Carrying Amount		Fair Value
		(in thousands)
Financial assets
Cash and due from banks	Level 1	$	401,228	$	401,228	$	390,078	$	390,078
Interest bearing deposits with banks	Level 1		299,097		299,097		463,022		463,022
Investment securities held to maturity:
U.S. Treasury securities	Level 1		99,792		108,734		99,869		115,329
Obligations of states and political subdivisions	Level 2		542,154		542,614		506,473		531,966
Residential mortgage-backed securities	Level 2		969,341		963,575		813,647		838,116
Trust preferred securities	Level 2		103,453		91,348		127,505		113,657
Corporate and other debt securities	Level 2		52,207		57,910		52,213		58,882

Total investment securities held to maturity			1,766,947		1,764,181		1,599,707		1,657,950

Net loans	Level 3		10,765,581		10,734,500		10,892,599		10,908,742
Accrued interest receivable	Level 1		53,303		53,303		52,375		52,375
Federal Reserve Bank and Federal Home Loan Bank stock⁽¹⁾	Level 1		138,359		138,359		138,533		138,533

Financial liabilities
Deposits without stated maturities	Level 1		8,877,529		8,877,529		8,755,252		8,755,252
Deposits with stated maturities	Level 2		2,365,093		2,404,271		2,508,766		2,563,726
Short-term borrowings	Level 1		125,060		125,060		154,323		154,323
Long-term borrowings	Level 2		2,695,897		2,994,601		2,697,299		3,100,173
Junior subordinated debentures issued to capital trusts	Level 2		41,008		42,731		40,927		40,776
Accrued interest payable⁽²⁾	Level 1		16,766		16,766		15,917		15,917

⁽¹⁾	Included in other assets.

⁽²⁾	Included in accrued expenses and other liabilities.

The following methods and assumptions that were used to estimate the fair value of other financial assets and financial liabilities in the table above:

Cash and due from banks and interest bearing deposits with banks. The carrying amount is considered to be a reasonable estimate of fair value because of the short maturity of these items.

Investment securities held to maturity. Fair values are based on prices obtained through an independent pricing service or dealer market participants with whom Valley has historically transacted both purchases and sales of investment securities. Prices obtained from these sources include prices derived from market quotations and matrix pricing. 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 (Level 2 inputs). Additionally, Valley reviews the volume and level of activity for all classes of held to maturity securities and attempts to identify transactions which may not be orderly or reflective of a significant level of activity and volume. For securities meeting these criteria, the quoted prices received from either market participants or an independent pricing service may be adjusted, as necessary. If applicable, the adjustment to fair value is derived based on present value cash flow model projections prepared by Valley utilizing assumptions similar to those incorporated by market participants.

Loans. Fair values of non-covered loans (i.e., loans which are not subject to loss-sharing agreements with the FDIC) and covered loans (i.e., loans subject to loss-sharing agreements with the FDIC) are estimated by discounting the projected future cash flows using market discount rates that reflect the credit and interest-rate risk inherent in the loan. The discount rate is a product of both the applicable index and credit spread, subject to the estimated current new loan interest rates. The credit spread component is static for all maturities and may not necessarily reflect the value of estimating all actual cash flows re-pricing. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Fair values estimated in this manner do not fully incorporate an exit-price approach to fair value, but instead are based on a comparison to current market rates for comparable loans.

Accrued interest receivable and payable. The carrying amounts of accrued interest approximate their fair value due to the short-term nature of these items.

Federal Reserve Bank and Federal Home Loan Bank stock. FRB and FHLB stock are non-marketable equity securities and are reported at their redeemable carrying amounts, which approximate the fair value.

Deposits. The carrying amounts of deposits without stated maturities (i.e., non-interest bearing, savings, NOW, and money market deposits) approximate their estimated fair value. The fair value of time deposits is based on the discounted value of contractual cash flows using estimated rates currently offered for alternative funding sources of similar remaining maturity.

Short-term and long-term borrowings. The carrying amounts of certain short-term borrowings, including securities sold under agreement to repurchase (and from time to time, federal funds purchased and FHLB borrowings) approximate their fair values because they frequently re-price to a market rate. The fair values of other short-term and long-term borrowings are estimated by obtaining quoted market prices of the identical or similar financial instruments when available. When quoted prices are unavailable, the fair values of the borrowings are estimated by discounting the estimated future cash flows using current market discount rates of financial instruments with similar characteristics, terms and remaining maturity.

Junior subordinated debentures issued to capital trusts (excluding VNB Capital Trust I). There is no active market for the trust preferred securities issued by Valley capital trusts, except for the securities issued by VNB Capital Trust I whose related debentures are carried at fair value. Therefore, the fair value of debentures not carried at fair value is estimated utilizing the income approach, whereby the expected cash flows, over the remaining estimated life of the security, are discounted using Valley’s credit spread over the current yield on a similar maturity of U.S. Treasury security or the three-month LIBOR for the variable rate indexed debentures (Level 2 inputs). Valley’s credit spread was calculated based on the exchange quoted price for Valley’s trust preferred securities issued by VNB Capital Trust I.