Fair value measurement

3 Months Ended

Mar. 31, 2017

Note 24 – Fair value measurement

ASC Subtopic 820-10 “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three levels in order to increase consistency and comparability in fair value measurements and disclosures. The hierarchy is broken down into three levels based on the reliability of inputs as follows:

Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access at the measurement date. Valuation on these instruments does not necessitate a significant degree of judgment since valuations are based on quoted prices that are readily available in an active market.
Level 2 - Quoted prices other than those included in Level 1 that are observable either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or that can be corroborated by observable market data for substantially the full term of the financial instrument.
Level 3 - Inputs are unobservable and significant to the fair value measurement. Unobservable inputs reflect the Corporation’s own assumptions about assumptions that market participants would use in pricing the asset or liability.

The Corporation maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Fair value is based upon quoted market prices when available. If listed prices or quotes are not available, the Corporation employs internally-developed models that primarily use market-based inputs including yield curves, interest rates, volatilities, and credit curves, among others. Valuation adjustments are limited to those necessary to ensure that the financial instrument’s fair value is adequately representative of the price that would be received or paid in the marketplace. These adjustments include amounts that reflect counterparty credit quality, the Corporation’s credit standing, constraints on liquidity and unobservable parameters that are applied consistently. There have been no changes in the Corporation’s methodologies used to estimate the fair value of assets and liabilities from those disclosed in the 2016 Form 10-K.

The estimated fair value may be subjective in nature and may involve uncertainties and matters of significant judgment for certain financial instruments. Changes in the underlying assumptions used in calculating fair value could significantly affect the results.

Fair Value on a Recurring and Nonrecurring Basis

The following fair value hierarchy tables present information about the Corporation’s assets and liabilities measured at fair value on a recurring basis at March 31, 2017 and December 31, 2016:

At March 31, 2017

(In thousands)	Level 1		Level 2		Level 3		Total

RECURRING FAIR VALUE MEASUREMENTS

Assets
Investment securities available-for-sale:
U.S. Treasury securities	$	-	$	2,943,120	$	-	$	2,943,120
Obligations of U.S. Government sponsored entities		-		712,282		-		712,282
Obligations of Puerto Rico, States and political subdivisions		-		20,909		-		20,909
Collateralized mortgage obligations - federal agencies		-		1,146,886		-		1,146,886
Mortgage-backed securities		-		4,361,767		1,289		4,363,056
Equity securities		-		1,859		-		1,859
Other		-		9,415		-		9,415
Total investment securities available-for-sale	$	-	$	9,196,238	$	1,289	$	9,197,527

Trading account securities:
Obligations of Puerto Rico, States and political subdivisions	$	-	$	189	$	-	$	189
Collateralized mortgage obligations		-		-		1,061		1,061
Mortgage-backed securities - federal agencies		-		31,279		4,345		35,624
Other		-		13,528		583		14,111
Total trading account securities	$	-	$	44,996	$	5,989	$	50,985
Mortgage servicing rights	$	-	$	-	$	193,698	$	193,698
Derivatives		-		13,097		-		13,097
Total assets measured at fair value on a recurring basis	$	-	$	9,254,331	$	200,976	$	9,455,307
Liabilities
Derivatives	$	-	$	(11,196)	$	-	$	(11,196)
Contingent consideration		-		-		(160,543)		(160,543)
Total liabilities measured at fair value on a recurring basis	$	-	$	(11,196)	$	(160,543)	$	(171,739)

At December 31, 2016

(In thousands)	Level 1		Level 2		Level 3		Total

RECURRING FAIR VALUE MEASUREMENTS

Assets
Investment securities available-for-sale:
U.S. Treasury securities	$	-	$	2,136,620	$	-	$	2,136,620
Obligations of U.S. Government sponsored entities		-		711,850		-		711,850
Obligations of Puerto Rico, States and political subdivisions		-		22,771		-		22,771
Collateralized mortgage obligations - federal agencies		-		1,221,526		-		1,221,526
Mortgage-backed securities		-		4,103,940		1,392		4,105,332
Equity securities		-		2,122		-		2,122
Other		-		9,585		-		9,585
Total investment securities available-for-sale	$	-	$	8,208,414	$	1,392	$	8,209,806

Trading account securities, excluding derivatives:
Obligations of Puerto Rico, States and political subdivisions	$	-	$	1,164	$	-	$	1,164
Collateralized mortgage obligations		-		-		1,321		1,321
Mortgage-backed securities - federal agencies		-		37,991		4,755		42,746
Other		-		13,963		602		14,565
Total trading account securities, excluding derivatives	$	-	$	53,118	$	6,678	$	59,796
Mortgage servicing rights	$	-	$	-	$	196,889	$	196,889
Derivatives		-		14,094		-		14,094
Total assets measured at fair value on a recurring basis	$	-	$	8,275,626	$	204,959	$	8,480,585
Liabilities
Derivatives	$	-	$	(12,842)	$	-	$	(12,842)
Contingent consideration		-		-		(153,158)		(153,158)
Total liabilities measured at fair value on a recurring basis	$	-	$	(12,842)	$	(153,158)	$	(166,000)

The fair value information included in the following tables is not as of period end, but as of the date that the fair value measurement was recorded during the quarters ended March 31, 2017 and 2016 and excludes nonrecurring fair value measurements of assets no longer outstanding as of the reporting date.

Quarter ended March 31, 2017

(In thousands)		Level 1		Level 2		Level 3		Total

NONRECURRING FAIR VALUE MEASUREMENTS
Assets											Write-downs
	Loans^[1]	$	-	$	-	$	45,133	$	45,133	$	(16,491)
	Other real estate owned^[2]		-		-		17,155		17,155		(4,578)
	Other foreclosed assets^[2]		-		-		165		165		(73)
Total assets measured at fair value on a nonrecurring basis		$	-	$	-	$	62,453	$	62,453	$	(21,142)

1] Relates mostly to certain impaired collateral dependent loans. The impairment was measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, in accordance with the provisions of ASC Section 310-10-35. Costs to sell are excluded from the reported fair value amount

[2] Represents the fair value of foreclosed real estate and other collateral owned that were written down to their fair value. Costs to sell are excluded from the reported fair value amount.

Quarter ended March 31, 2016

(In thousands)		Level 1		Level 2		Level 3		Total

NONRECURRING FAIR VALUE MEASUREMENTS
Assets											Write-downs
	Loans^[1]	$	-	$	-	$	30,785	$	30,785	$	(22,850)
	Loans held-for-sale^[2]		-		-		1,829		1,829		(296)
	Other real estate owned^[3]		-		-		18,592		18,592		(3,920)
	Other foreclosed assets^[3]		-		-		66		66		(11)
Total assets measured at fair value on a nonrecurring basis		$	-	$	-	$	51,272	$	51,272	$	(27,077)

[1] Relates mostly to certain impaired collateral dependent loans. The impairment was measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations, in accordance with the provisions of ASC Section 310-10-35. Costs to sell are excluded from the reported fair value amount.

[2] Relates to lower of cost or fair value adjustments on loans held-for-sale and loans transferred from loans held-in-portfolio to loans held-for-sale. Costs to sell are excluded from the reported fair value amount.

[3] Represents the fair value of foreclosed real estate and other collateral owned that were written down to their fair value. Costs to sell are excluded from the reported fair value amount.

The following tables present the changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the quarters ended March 31, 2017 and 2016.

	Quarter ended March 31, 2017
		MBS						Other
		classified		CMOs				securities
		as investment		classified		MBS		classified
		securities		as trading		classified as		as trading		Mortgage
		available-		account		trading account		account		servicing		Total		Contingent		Total
(In thousands)		for-sale		securities		securities		securities		rights		assets		consideration		liabilities
Balance at January 1, 2017		$	1,392	$	1,321	$	4,755	$	602	$	196,889	$	204,959	$	(153,158)	$	(153,158)
Gains (losses) included in earnings			-		(4)		(43)		(19)		(5,954)		(6,020)		(7,385)		(7,385)
Gains (losses) included in OCI			10		-		-		-		-		10		-		-
Additions			-		-		164		-		2,763		2,927		-		-
Sales			-		(205)		(156)		-		-		(361)		-		-
Settlements			(25)		(51)		(375)		-		-		(451)		-		-
Transfers out of Level 3			(88)		-		-		-		-		(88)		-		-
Balance at March 31, 2017		$	1,289	$	1,061	$	4,345	$	583	$	193,698	$	200,976	$	(160,543)	$	(160,543)
Changes in unrealized gains
	(losses) included in earnings
	relating to assets still held
	at March 31, 2017	$	-	$	(4)	$	(27)	$	9	$	(723)	$	(745)	$	(7,385)	$	(7,385)

	Quarter ended March 31, 2016
		MBS						Other
		classified		CMOs				securities
		as investment		classified		MBS		classified
		securities		as trading		classified as		as trading		Mortgage
		available-		account		trading account		account		servicing		Total		Contingent		Total
(In thousands)		for-sale		securities		securities		securities		rights		assets		consideration		liabilities
Balance at January 1, 2016		$	1,434	$	1,831	$	6,454	$	687	$	211,405	$	221,811	$	(120,380)	$	(120,380)
Gains (losses) included in earnings			(2)		(6)		89		(24)		(8,477)		(8,420)		(443)		(443)
Gains (losses) included in OCI			15		-		-		-		-		15		-		-
Additions			-		174		338		-		2,123		2,635		-		-
Sales			-		(106)		(1,120)		-		-		(1,226)		-		-
Settlements			(25)		(110)		(364)		-		-		(499)		-		-
Balance at March 31, 2016		$	1,422	$	1,783	$	5,397	$	663	$	205,051	$	214,316	$	(120,823)	$	(120,823)
Changes in unrealized gains
	(losses) included in earnings
	relating to assets still held
	at March 31, 2016	$	-	$	(3)	$	86	$	11	$	(3,866)	$	(3,772)	$	(443)	$	(443)

During the quarter ended March 31, 2017, a certain MBS amounting to $88 thousand was transferred from Level 3 to Level 2 due to a change in valuation technique from an internally-prepared pricing matrix to a bond’s theoretical value. There were no transfers in and/or out of Level 1, Level 2, or Level 3 for financial instruments measured at fair value on a recurring basis during the quarter ended March 31, 2016.

Gains and losses (realized and unrealized) included in earnings for the quarters ended March 31, 2017 and 2016 for Level 3 assets and liabilities included in the previous tables are reported in the consolidated statements of operations as follows:

	Quarter ended March 31, 2017				Quarter ended March 31, 2016
				Changes in unrealized				Changes in unrealized
		Total gains		gains (losses) relating to		Total gains		gains (losses) relating to
		(losses) included		assets still held at		(losses) included		assets still held at
(In thousands)		in earnings		reporting date		in earnings		reporting date

Interest income	$	-	$	-	$	(2)	$	-
FDIC loss share expense		(7,385)		(7,385)		(443)		(443)
Mortgage banking activities		(5,954)		(723)		(8,477)		(3,866)
Trading account loss		(66)		(22)		59		94
Total	$	(13,405)	$	(8,130)	$	(8,863)	$	(4,215)

The following table includes quantitative information about significant unobservable inputs used to derive the fair value of Level 3 instruments, excluding those instruments for which the unobservable inputs were not developed by the Corporation such as prices of prior transactions and/or unadjusted third-party pricing sources.

		Fair value
		at March 31,
(In thousands)		2017	Valuation technique	Unobservable inputs	Weighted average (range)
CMO's - trading	$	1,061	Discounted cash flow model	Weighted average life	2.8 years (0.1 - 4.1 years)
				Yield	3.5% (0.7% - 4.2%)
				Prepayment speed	20.3% (18.0% - 22.4%)
Other - trading	$	583	Discounted cash flow model	Weighted average life	5.4	years
				Yield	12.3	%
				Prepayment speed	10.8	%
Mortgage servicing rights	$	193,698	Discounted cash flow model	Prepayment speed	5.3% (0.2% - 15.5%)
				Weighted average life	7.0 years (0.1 - 16.6 years)
				Discount rate	11.2% (9.5% - 15.0%)
Contingent consideration	$	(160,543)	Discounted cash flow model	Credit loss rate on covered loans	3.5% (0.0% - 100.0%)
				Risk premium component
				of discount rate	3.4	%
Loans held-in-portfolio	$	45,133 ^[1]	External appraisal	Haircut applied on
				external appraisals	25.1% (22.5% - 27.1%)
Other real estate owned	$	14,049 ^[2]	External appraisal	Haircut applied on
				external appraisals	15.5% (15.0% - 30.0%)

[1] Loans held-in-portfolio in which haircuts were not applied to external appraisals were excluded from this table.

[2] Other real estate owned in which haircuts were not applied to external appraisals were excluded from this table.

The significant unobservable inputs used in the fair value measurement of the Corporation’s collateralized mortgage obligations and interest-only collateralized mortgage obligation (reported as “other”), which are classified in the “trading” category, are yield, constant prepayment rate, and weighted average life. Significant increases (decreases) in any of those inputs in isolation would result in significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the constant prepayment rate will generate a directionally opposite change in the weighted average life. For example, as the average life is reduced by a higher constant prepayment rate, a lower yield will be realized, and when there is a reduction in the constant prepayment rate, the average life of these collateralized mortgage obligations will extend, thus resulting in a higher yield. These particular financial instruments are valued internally by the Corporation’s investment banking and broker-dealer unit utilizing internal valuation techniques. The unobservable inputs incorporated into the internal discounted cash flow models used to derive the fair value of collateralized mortgage obligations and interest-only collateralized mortgage obligation (reported as “other”), which are classified in the “trading” category, are reviewed by the Corporation’s Corporate Treasury unit on a quarterly basis. In the case of Level 3 financial instruments which fair value is based on broker quotes, the Corporation’s Corporate Treasury unit reviews the inputs used by the broker-dealers for reasonableness utilizing information available from other published sources and validates that the fair value measurements were developed in accordance with ASC Topic 820. The Corporate Treasury unit also substantiates the inputs used by validating the prices with other broker-dealers, whenever possible.

The significant unobservable inputs used in the fair value measurement of the Corporation’s mortgage servicing rights are constant prepayment rates and discount rates. Increases in interest rates may result in lower prepayments. Discount rates vary according to products and / or portfolios depending on the perceived risk. Increases in discount rates result in a lower fair value measurement. The Corporation’s Corporate Comptroller’s unit is responsible for determining the fair value of MSRs, which is based on discounted cash flow methods based on assumptions developed by an external service provider, except for prepayment speeds, which are adjusted internally for the local market based on historical experience. The Corporation’s Corporate Treasury unit validates the economic assumptions developed by the external service provider on a quarterly basis. In addition, an analytical review of prepayment speeds is performed quarterly by the Corporate Comptroller’s unit. The Corporation’s MSR Committee analyzes changes in fair value measurements of MSRs and approves the valuation assumptions at each reporting period. Changes in valuation assumptions must also be approved by the MSR Committee. The fair value of MSRs are compared with those of the external service provider on a quarterly basis in order to validate if the fair values are within the materiality thresholds established by management to monitor and investigate material deviations. Back-testing is performed to compare projected cash flows with actual historical data to ascertain the reasonability of the projected net cash flow results.

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

+ References + Details