Mortgage Banking

Loans Sold

For the year ended December 31, 2017, 2016 and 2015, the Company sold $218.6 million, $232.2 million and $61.2 million, 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 $6.3 million, $6.2 million, and $1.3 million, respectively.

Loans Held for Sale

At December 31, 2017 and 2016, the Company had identified and designated loans with an unpaid principal balance of $8.1 million and $15.1 million, respectively, as held for sale. The Company has elected the fair value option for its loans designated as held for sale, and, at December 31, 2017 and 2016, the unrealized gain (loss) recorded was $37,000 and ($289,000), respectively. The unrealized gain or loss on its loans held for sale portfolio was driven by changes in market interest rates and not due to deteriorated credit quality as this risk is mitigated by the short duration between the time of the loan closed and transfer of the financial assets to the secondary market investor. Included within the Company's mortgage banking income, net on its consolidated statements of income for the year ended December 31, 2017, 2016 and 2015 was the change in unrealized gains (losses) on loans held for sale of $326,000, $(422,000) and $133,000, respectively.

The Company mitigates its interest rate exposure on its loans designated as held for sale through forward delivery commitments with certain approved secondary market investors at the onset of the mortgage origination process, typically on a best-efforts basis. For the year ended December 31, 2017, 2016 and 2015, the Company recorded gains (losses) on its forward delivery commitments of ($136,000), $278,000, and $0, respectively. Refer to Note 18 for further discussion of the Company's forward delivery commitments.

Servicing Assets

At December 31, 2017 and 2016, the Company's unpaid principal balances on its servicing assets were $275.2 million and $332.7 million, respectively.

For the year ended December 31, 2017, 2016 and 2015, the Company recorded servicing fee income for its servicing assets of $1.0 million, $1.1 million and $597,000, respectively, and was presented in mortgage banking income, net on the consolidated statements of income.

The Company's servicing assets, net of a valuation allowance, included in other assets on the consolidated statements of condition at December 31, 2017 and 2016 was $1.0 million and $1.2 million, respectively.

The Company obtains third party valuations of its servicing assets portfolio quarterly. The servicing assets valuation is based on loan level data stratified by note rate of the underlying loans to determine its amortization and fair value. A discounted cash flow model is used to value each servicing asset strata and it incorporates current market assumption commonly used by buyers of these types of mortgage production in U.S. servicing markets. The calculated valuation using the discounted cash flow method is then compared to recent servicing trades on portfolios with similar characteristics in the U.S. The valuation 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. At December 31, 2017 and 2016, the prepayment assumption used within the valuation model was 14.0% and 14.6%, respectively, and the discount rate was 11.2% and 7.8%. The estimated effect of a 10% and 20% increase to the prepayment assumption at December 31, 2017 was a decrease of $76,000 and $148,000, respectively, while a 100 and 200 basis points increase to the discount rate assumption was a decrease of $54,000 and $105,000. Other assumptions include, but are not limited to, delinquency rates, foreclosure rates, and loan servicing cost.

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



	As of and For The Year Ended December 31,
	2017			2016			2015
Servicing Assets:
Balance at beginning of year	$	1,210		$	2,161		$	493
Capitalized servicing right fees upon sale⁽¹⁾	22			9			294
Acquired in connection with acquisition of SBM, at fair value	—			—			1,608
Amortization charged against mortgage servicing fee income⁽¹⁾	(430		)	(734		)	(231		)
Valuation adjustment	223			(226		)	(3		)
Balance at end of year	$	1,025		$	1,210		$	2,161
Valuation Allowance:
Balance at beginning of year	$	(230	)	$	(4	)	$	(1	)
(Increase) decrease in impairment reserve⁽¹⁾	223			(226		)	(3		)
Balance at end of year	$	(7	)	$	(230	)	$	(4	)
Fair value, beginning of year	$	1,701		$	2,947		$	1,447
Fair value, end of year	$	1,766		$	1,701		$	2,947


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

Sub-Serviced Loans

Mortgage loans serviced for third party investors, for which the Company acts in a sub-servicer capacity and, therefore, does not have a corresponding servicing asset, are not reported as assets of the Company on its consolidated statements of condition. The unpaid principal balance on mortgage loans serviced for investors at December 31, 2017 and 2016 was $349.7 million and $930.8 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 $4.2 million and $11.9 million at December 31, 2017 and 2016, respectively. The Company recognized sub-servicing fee income, including related loan fees, for the years ended December 31, 2017, 2016 and 2015 of $12,000, $1.7 million, and $1.2 million. Effective close of business on December 31, 2016, the Company exited a significant sub-servicer relationship.

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, 2017 and 2016, the Company advanced escrow balances of $194,000 and $2.0 million, respectively, and had a receivable of $58,000 and $2.7 million, respectively, for the aforementioned services. At December 31, 2017 and 2016, the Company carried an allowance on the aforementioned receivable of $0 and $829,000, 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.

Servicer and Sub-Servicer Net Worth and Liquidity Requirements

The Bank, as a servicer and sub-servicer of loans, must maintain certain net worth and liquidity requirements for certain secondary market investors, including the U.S. Department of Housing and Urban Development ("HUD"), the Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").

The Bank is required to maintain a minimum net worth of $1.0 million plus 1.0% of total Federal Housing Authority ("FHA") loans exceeding $25.0 million ("minimum net worth required") and maintain liquid assets equal to at least 20.0% of its minimum net worth required.

The Bank is required to maintain a minimum net worth of $2.5 million plus 25 basis points of the unpaid principal balance of serviced loans and must meet the minimum regulatory capital requirement to be classified as "well capitalized" by both FNMA and FHLMC.

Should the Bank fail to maintain the net worth and liquidity requirements above, the secondary market investor may take remedial action and the Company may lose the right to service the loans, which may result in an impairment of its servicing assets and/or loss of revenue but would not materially affect the Company's consolidated financial statements.

At December 31, 2017 and 2016, the Bank met all of the aforementioned minimum net worth, regulatory capital, and liquidity requirements. Refer to Note 13 for further details of the Company and Bank's regulatory capital requirements at December 31, 2017 and 2016.