Fair Value Measurements

The Corporation uses fair value measurements to record fair value adjustments on certain assets and liabilities and to determine fair value disclosures. As of September 30, 2018 and December 31, 2017, securities available for sale, residential real estate mortgage loans held for sale, derivatives and the contingent consideration liability are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as collateral dependent impaired loans, property acquired through foreclosure or repossession and mortgage servicing rights. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write-downs of individual assets.

Fair value is a market-based measurement, not an entity-specific measurement. Fair value measurements are determined based on the assumptions the market participants would use in pricing the asset or liability. In addition, GAAP specifies a hierarchy of valuation techniques based on whether the types of valuation information (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Corporation’s market assumptions. These two types of inputs have created the following fair value hierarchy:


•	Level 1 – Quoted prices for identical assets or liabilities in active markets.


•	Level 2 – Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.


•	Level 3 – Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable in the markets and which reflect the Corporation’s market assumptions.

Fair Value Option Election

GAAP allows for the irrevocable option to elect fair value accounting for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis. The Corporation has elected the fair value option for residential real estate mortgage loans held for sale to better match changes in fair value of the loans with changes in the fair value of the forward sale commitment contracts used to economically hedge them.

The aggregate principal amount of the residential real estate mortgage loans held for sale recorded at fair value was $22.3 million and $26.4 million, respectively, at September 30, 2018 and December 31, 2017. The aggregate fair value of these loans as of the same dates was $22.6 million and $26.9 million, respectively. As of September 30, 2018 and December 31, 2017, the aggregate fair value of residential real estate mortgage loans held for sale exceeded the aggregate principal amount by $303 thousand and $543 thousand, respectively.

There were no residential real estate mortgage loans held for sale 90 days or more past due as of September 30, 2018 and December 31, 2017.

Changes in fair value of mortgage loans held for sale accounted for under the fair value option election amounted to decreases of $352 thousand and $240 thousand, respectively, in the three and nine months ended September 30, 2018, compared to a decrease of $81 thousand and an increase of $693 thousand, respectively, in the three and nine months ended September 30, 2017. These amounts were partially offset in earnings by the changes in fair value of forward sale commitments used to economically hedge them. The changes in fair value are reported as a component of mortgage banking revenues in the Unaudited Consolidated Statements of Income.

Valuation Techniques

Securities

Securities available for sale are recorded at fair value on a recurring basis. When available, the Corporation uses quoted market prices to determine the fair value of securities; such items are classified as Level 1. There were no Level 1 securities held at September 30, 2018 and December 31, 2017.

Level 2 securities include debt securities with quoted prices, which are traded less frequently than exchange-traded instruments. The fair value of these securities is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category includes obligations of U.S. government-sponsored enterprises, including mortgage-backed securities, obligations of states and political subdivisions, individual name issuer trust preferred debt securities and corporate bonds.

Securities not actively traded whose fair value is determined through the use of cash flows utilizing inputs that are unobservable are classified as Level 3. There were no Level 3 securities held at September 30, 2018 and December 31, 2017.

Mortgage Loans Held for Sale

The fair value of mortgage loans held for sale is estimated based on current market prices for similar loans in the secondary market and therefore are classified as Level 2 assets.

Collateral Dependent Impaired Loans

The fair value of collateral dependent loans that are deemed to be impaired is determined based upon the fair value of the underlying collateral. Such collateral primarily consists of real estate and, to a lesser extent, other business assets. For collateral dependent loans for which repayment is dependent on the sale of the collateral, management adjusts the fair value for estimated costs to sell. For collateral dependent loans for which repayment is dependent on the operation of the collateral, such as accruing troubled debt restructured loans, estimated costs to sell are not incorporated into the measurement. Management may also adjust appraised values to reflect estimated market value declines or apply other discounts to appraised values resulting from its knowledge of the property. Internal valuations are utilized to determine the fair value of other business assets. Collateral dependent impaired loans are categorized as Level 3.

Property Acquired Through Foreclosure or Repossession

Property acquired through foreclosure or repossession included in other assets in the Unaudited Consolidated Balance Sheets is adjusted to fair value less costs to sell upon transfer out of loans through a charge to allowance for loan losses. Subsequently, it is carried at the lower of carrying value or fair value less costs to sell. Such subsequent valuation charges are charged through earnings. Fair value is generally based upon appraised values of the collateral. Management may adjust appraised values to reflect estimated market value declines or apply other discounts to appraised values for unobservable factors resulting from its knowledge of the property, and such property is categorized as Level 3.

Derivatives

Interest rate cap, swap and floor contracts are traded in over-the-counter markets where quoted market prices are not readily available. Fair value measurements are determined using independent pricing models that utilize primarily market observable inputs, such as swap rates of different maturities and LIBOR rates. The Corporation also evaluates the credit risk of its counterparties as well as that of the Corporation. Accordingly, Washington Trust considers factors such as the likelihood of default by the Corporation and its counterparties, its net exposures and remaining contractual life, among other factors, in determining if any fair value adjustments related to credit risk are required. Counterparty exposure is evaluated by netting positions that are subject to master netting agreements, as well as considering the amount of collateral securing the position, if any. Although the Corporation has determined that the majority of the inputs used to value its interest rate swap, cap and floor contracts fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with interest rate contracts and risk participation agreements utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by the Corporation and its counterparties. However, as of September 30, 2018 and December 31, 2017, the Corporation has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Corporation has classified its derivative valuations in their entirety as Level 2.

Fair value measurements of forward loan commitments (interest rate lock commitments and forward sale commitments) are primarily based on current market prices for similar assets in the secondary market for mortgage loans and therefore are classified as Level 2 assets. The fair value of interest rate lock commitments is also dependent on the ultimate closing of the loans. Pull-through rates are based on the Corporation’s historical data and reflect the Corporation’s best estimate of the likelihood that a commitment will result in a closed loan. Although the pull-through rates are Level 3 inputs, the Corporation has assessed the significance of the impact of pull-through rates on the overall valuation of its interest rate lock commitments and has determined that they are not significant to the overall valuation. As a result, the Corporation has classified its interest rate lock commitments as Level 2.

Contingent Consideration Liability

A contingent consideration liability was recognized upon the completion of the Halsey acquisition on August 1, 2015 representing the estimated present value of future earn-outs to be paid based on the future revenue growth of the acquired business during the five-year period following the acquisition.

The fair value measurement is based upon unobservable inputs, therefore, the contingent liability is classified within Level 3 of the fair value hierarchy. The unobservable inputs include probability estimates regarding the likelihood of achieving revenue growth targets and the discount rates utilized the discounted cash flow calculations applied to the estimates earn-outs to be paid. The contingent consideration liability is remeasured to fair value at each reporting period taking into consideration changes in those unobservable inputs. Changes in the fair value of the contingent consideration liability are included in noninterest expenses in the Unaudited Consolidated Statements of Income.

One of the two earn-out periods associated with this contingent consideration liability ended December 31, 2017 and a payment of $1.2 million was made by the Corporation in the first quarter of 2018.

The fair value of the contingency represents the estimated price to transfer the liability between market participants at the measurement date under current market conditions.

Items Recorded at Fair Value on a Recurring Basis

The following tables present the balances of assets and liabilities reported at fair value on a recurring basis:



(Dollars in thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2018	Total				Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available for sale:
Obligations of U.S. government-sponsored enterprises		$193,473		$—		$193,473		$—
Mortgage-backed securities issued by U.S. government agencies and U.S. government-sponsored enterprises	592,862		—		592,862		—
Obligations of states and political subdivisions	937		—		937		—
Individual name issuer trust preferred debt securities	12,464		—		12,464		—
Corporate bonds	12,911		—		12,911		—
Mortgage loans held for sale	22,571		—		22,571		—
Derivative assets	20,242		—		20,242		—
Total assets at fair value on a recurring basis		$855,460		$—		$855,460		$—
Liabilities:
Derivative liabilities		$17,822		$—		$17,822		$—
Contingent consideration liability	187		—		—		187
Total liabilities at fair value on a recurring basis		$18,009		$—		$17,822		$187



(Dollars in thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
December 31, 2017	Total				Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available for sale:
Obligations of U.S. government-sponsored enterprises		$157,604		$—		$157,604		$—
Mortgage-backed securities issued by U.S. government agencies and U.S. government-sponsored enterprises	590,882		—		590,882		—
Obligations of states and political subdivisions	2,359		—		2,359		—
Individual name issuer trust preferred debt securities	16,984		—		16,984		—
Corporate bonds	13,125		—		13,125		—
Mortgage loans held for sale	26,943		—		26,943		—
Derivative assets	2,759		—		2,759		—
Total assets at fair value on a recurring basis		$810,656		$—		$810,656		$—
Liabilities:
Derivative liabilities		$3,047		$—		$3,047		$—
Contingent consideration liability	1,404		—		—		1,404
Total liabilities at fair value on a recurring basis		$4,451		$—		$3,047		$1,404

It is the Corporation’s policy to review and reflect transfers between Levels as of the financial statement reporting date. There were no transfers in and/or out of Level 1, 2 or 3 during the nine months ended September 30, 2018 and 2017.

The contingent consideration liability is a Level 3 liability remeasured to fair value on a recurring basis. The following table presents the change in the contingent consideration liability, which is included in other liabilities in the Unaudited Consolidated Balance Sheets.



(Dollars in thousands)	Three Months				Nine Months
Periods ended September 30,	2018		2017		2018			2017
Balance at beginning of period		$187		$1,737		$1,404			$2,047
Change in fair value	—		—		—			(310		)
Payments	—		—		(1,217		)	—
Balance at end of period		$187		$1,737		$187			$1,737

Items Recorded at Fair Value on a Nonrecurring Basis

The following table presents the carrying value of assets held at September 30, 2018, which were written down to fair value during the nine months ended September 30, 2018:



(Dollars in thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
(Dollars in thousands)	Total				Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Collateral dependent impaired loans		$27		$—		$—		$27
Property acquired through foreclosure or repossession	2,974		—		—		2,974
Total assets at fair value on a nonrecurring basis		$3,001		$—		$—		$3,001

The allowance for loan losses on collateral dependent impaired loans amounted to $8 thousand at September 30, 2018.

The following table presents the carrying value of assets held at December 31, 2017, which were written down to fair value during the year ended December 31, 2017:



(Dollars in thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
(Dollars in thousands)	Total				Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Collateral dependent impaired loans		$1,425		$—		$—		$1,425
Property acquired through foreclosure or repossession	131		—		—		131
Total assets at fair value on a nonrecurring basis		$1,556		$—		$—		$1,556

The allowance for loan losses on collateral dependent impaired loans amounted to $690 thousand at December 31, 2017.

The following tables present valuation techniques and unobservable inputs for assets measured at fair value on a nonrecurring basis for which the Corporation has utilized Level 3 inputs to determine fair value:



(Dollars in thousands)	Fair Value		Valuation Technique	Unobservable Input	Range of Inputs Utilized (Weighted Average)
September 30, 2018	Fair Value		Valuation Technique	Unobservable Input	Range of Inputs Utilized (Weighted Average)
Collateral dependent impaired loans		$27	Appraisals of collateral	Discount for costs to sell	0% - 10% (8%)

Property acquired through foreclosure or repossession		$2,974	Appraisals of collateral	Discount for costs to sell	13%
				Appraisal adjustments (1)	12%


(1)	Management may adjust appraisal values to reflect market value declines or other discounts resulting from its knowledge of the property.



(Dollars in thousands)	Fair Value		Valuation Technique	Unobservable Input	Range of Inputs Utilized (Weighted Average)
December 31, 2017	Fair Value		Valuation Technique	Unobservable Input	Range of Inputs Utilized (Weighted Average)
Collateral dependent impaired loans		$1,425	Appraisals of collateral	Discount for costs to sell	0% - 15% (15%)

Property acquired through foreclosure or repossession		$131	Appraisals of collateral	Discount for costs to sell	10%
				Appraisal adjustments (1)	12% - 17% (15%)


(1)	Management may adjust appraisal values to reflect market value declines or other discounts resulting from its knowledge of the property.

Valuation of Other Financial Instruments

The following tables present the carrying amount, estimated fair value and placement in the fair value hierarchy of the Corporation’s financial instruments. The tables exclude financial instruments for which the carrying value approximates fair value such as cash and cash equivalents, FHLB stock, accrued interest receivable, bank-owned life insurance, non-maturity deposits and accrued interest payable.



(Dollars in thousands)
September 30, 2018	Carrying Amount		Total Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets:
Securities held to maturity		$10,863		$10,657		$—		$10,657		$—
Loans, net of allowance for loan losses	3,529,694		3,500,065		—		—		3,500,065

Financial Liabilities:
Time deposits		$1,159,218		$1,170,151		$—		$1,170,151		$—
FHLB advances	828,392		827,328		—		827,328		—
Junior subordinated debentures	22,681		19,844		—		19,844		—



(Dollars in thousands)
December 31, 2017	Carrying Amount		Total Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets:
Securities held to maturity		$12,541		$12,721		$—		$12,721		$—
Loans, net of allowance for loan losses	3,347,583		3,369,932		—		—		3,369,932

Financial Liabilities:
Time deposits		$1,015,095		$1,018,396		$—		$1,018,396		$—
FHLB advances	791,356		792,887		—		792,887		—
Junior subordinated debentures	22,681		18,559		—		18,559		—