Mortgage Banking

Residential real estate mortgages are originated by the Company both for its portfolio and for sale into the secondary market. The transfer of these financial assets is accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (i) the assets have been isolated from the Company, (ii) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (ii) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. The Company may sell its loans to institutional investors and may do so on either a servicing rights released basis or servicing rights retained basis. Should the Company enter into an agreement with the investor to retain or acquire the servicing rights, the Company will record a servicing asset. The Company will enter into an agreement with the investor to pay an agreed-upon rate on the loan, which is less than the interest rate received from the borrower. The Company will retain the difference as a fee for servicing the loan. The Company will capitalize the MSR at fair value within other assets on the statements of condition upon sale of the related loan, and subsequently amortize the asset over the estimated life of the serviced loan and assesses quarterly the asset for impairment. For the year ended December 31, 2016, 2015 and 2014, the Company earned servicing fee income for its servicing assets of $1.1 million, $597,000 and $484,000, respectively, and was presented in mortgage banking income, net on the consolidated statements of income.

For the year ended December 31, 2016, 2015 and 2014, the Company sold $232.2 million, $61.2 million and $799,000, respectively, of residential mortgage loans on the secondary market, which resulted in a net gain on sale of loans (net of costs, including direct and indirect origination costs) of $6.2 million, $1.3 million, and $31,000, respectively. Additionally, at December 31, 2016 and 2015, the Company had identified and designated loans with an unpaid principal balance of $15.1 million and $10.8 million, respectively, as held for sale. The Company elected the fair value option for its loans designated as held for sale, and at December 31, 2016, the unrealized loss was $289,000 and at December 31, 2015 the unrealized gain was $133,000. The unrealized gain or loss on its loans held for sale portfolio is driven by changes in market interest rates and is not impacted by credit quality risks associated with the borrower due to the short-term duration between time of closing and funding of the loan and sale. Included within the Company's mortgage banking income, net on its consolidated statements of income for the year ended December 31, 2016, 2015 and 2014 was the change in unrealized gains (losses) on loans held for sale of ($422,000), $133,000 and $0, respectively. The Company mitigates its interest rate exposure on its loans designated as held for sale through forward delivery commitments with investors at the onset of the mortgage origination process, typically on a "best-efforts" basis, with certain approved investors. Refer to Note 18 for further discussion of the Company's forward delivery commitments at December 31, 2016 and 2015 and the offsetting gain (losses) recorded on loans held for sale.

The Company's MSRs, net of a valuation allowance, included in other assets on the consolidated statements of condition at December 31, 2016 and 2015 was $1.2 million and $2.2 million, respectively.

The Company obtains third party valuations based on loan level data stratified by note rate, type and term of the underlying loans to determine MSR amortization and valuation. The model utilizes a variety of assumptions, the most significant of which are loan prepayment assumptions and the discount rate used to discount future cash flows. Prepayment assumptions, which are impacted by loan rates and terms, are calculated using a three-month moving average of weekly prepayment data published by the Public Securities Association and modeled against the serviced loan portfolio by the third party valuation specialist. The discount rate is the quarterly average 10-year U.S. Treasury rate plus a risk premium. At December 31, 2016 and 2015, the prepayment assumption used within the model was 14.6% and 11.0%, respectively, and the discount rate was 7.8% and 7.5%. The estimated effect of a 10% and 20% adverse change to the prepayment assumption at December 31, 2016 was a decrease of $97,000 and $185,000, respectively, while a 10% and 20% adverse change to the discount rate assumption was a decrease of $57,000 and $111,000. Other assumptions include delinquency rates, foreclosure rates, servicing cost inflation, and annual unit loan cost. All assumptions are adjusted periodically to reflect current circumstances.

The following summarizes MSRs capitalized and amortized, along with the activity in the related valuation allowance:



	As of and For The Year Ended December 31,
	2016			2015			2014
MSRs:
Balance at beginning of year	$	2,161		$	493		$	726
Capitalized servicing right fees upon sale⁽¹⁾	9			294			15
Acquired in connection with SBM acquisition, at fair value	—			1,608			—
Amortization charged against mortgage servicing fee income⁽¹⁾	(734		)	(231		)	(262		)
Valuation adjustment	(226		)	(3		)	14
Balance at end of year	$	1,210		$	2,161		$	493
Valuation Allowance:
Balance at beginning of year	$	(4	)	$	(1	)	$	(15	)
(Increase) decrease in impairment reserve⁽¹⁾	(226		)	(3		)	14
Balance at end of year	$	(230	)	$	(4	)	$	(1	)
Fair value, beginning of year⁽²⁾	$	2,947		$	1,447		$	1,494
Fair value, end of year⁽²⁾	$	1,701		$	2,947		$	1,447


(1)	Reported within mortgage banking income, net on the Company's consolidated statements of income.


(2)	Reported fair value represents all MSRs currently being serviced by the Company.

Mortgage loans serviced for third party investors, including mortgage loans where the Company serves as the sub-servicer for which it does not have a corresponding servicing right asset, are not included within the Company's loan portfolio on its consolidated statements of condition. The unpaid principal balance on mortgage loans serviced for investors at December 31, 2016 and 2015 was $930.8 million and $963.0 million, respectively. Custodial escrow balances maintained in connection with the foregoing loan servicing for investors, and included in demand deposits on the Company's consolidated statements of condition, were $11.9 million and $7.1 million at December 31, 2016 and 2015, respectively.

For the year ended December 31, 2016, 2015 and 2014, the Company served as the primary sub-servicer of loans originated by MSHA. The Company entered into a contract with MSHA to perform loan servicing on the MSHA portfolio for a fee. For the year ended December 31, 2016, 2015 and 2014, the Company earned fees of $1.7 million, $1.2 million, and $1.2 million, respectively, for the servicing of MSHA loans and was presented within other income on the consolidated statements of income. The MSHA unpaid principal balances of loans serviced by the Company, which are not included in the Company's portfolio loan balance within its consolidated statements of condition, totaled $619.1 million and $612.1 million at December 31, 2016 and 2015, respectively. Custodial escrow balances maintained in connection with the foregoing loan servicing for MSHA, and included in demand deposits on the consolidated statements of condition, were $6.3 million and $4.3 million at December 31, 2016 and 2015, respectively. Effective close of business on December 31, 2016, the Company exited its sub-servicer relationship with MSHA and all custodial escrow balances maintained in connection with the MSHA sub-servicing relationship were paid out in January 2017.

As part of its agreement to service loans for investors and its own loan portfolio, the Company is required to ensure the good-standing and priority lien position of the collateral for its mortgage loans. In doing so, the Company will advance borrower escrows and incur certain costs that are reimbursable by the borrowers, investors or other means, including mortgage insurance companies and governmental-backed agencies. At December 31, 2016 and 2015, the Company advanced escrow balances of $2.0 million and $4.9 million, respectively, and had a receivable of $2.7 million and $5.7 million, respectively, for the aforementioned services. At December 31, 2016 and 2015, the Company carried an allowance on the aforementioned receivable of $829,000 and $489,000, respectively. The Company estimated the allowance on its receivable utilizing historical claim and reimbursement information, as well as information through ongoing negotiations with its investors. The Company has presented its advanced escrows and aforementioned net receivable within other assets on the Company's consolidated statements of condition.

In addition to fees earned for servicing the portfolios of investors, servicer guides impose certain time-lines for resolving delinquent loans through workout efforts or liquidation and impose compensatory fees on the Company if those deadlines are not satisfied other than for reasons beyond our control. The investors also have a contractual right to demand indemnification or loan repurchase for certain servicing breaches. For example, the Company would be required to indemnify the investors for or against failures by the Company to perform its servicing obligations or acts or omissions that involve willful malfeasance, bad faith or gross negligence in the performance of, or reckless disregard of, its duties. The Company records expenses for servicing-related claims and loan repurchases when it is probable that such claims or repurchases will be made and the amounts are reasonably estimable.