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FAIR VALUE OF FINANCIAL INSTRUMENTS

9 Months Ended

Sep. 30, 2020

FAIR VALUE OF FINANCIAL INSTRUMENTS

The following table presents estimated fair values of the Company’s financial instruments as of September 30, 2020 and December 31, 2019, whether or not measured at fair value in the Consolidated Statements of Financial Condition (dollars in thousands):


		September 30, 2020				December 31, 2019
	Level	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
Assets:
Cash and cash equivalents	1	$	705,538	$	705,538	$	307,735	$	307,735
Securities—trading	3	23,276		23,276		25,636		25,636
Securities—available-for-sale	2	1,758,384		1,758,384		1,551,557		1,551,557
Securities—held-to-maturity	2	426,380		448,051		233,241		234,952
Securities—held-to-maturity	3	2,755		2,755		2,853		2,853
Loans held for sale	2	185,938		186,544		210,447		210,670
Loans receivable	3	10,163,917		10,091,600		9,305,357		9,304,340
Equity securities	1	450,255		450,255		—		—
FHLB stock	3	16,363		16,363		28,342		28,342
Bank-owned life insurance	1	191,755		191,755		192,088		192,088
Mortgage servicing rights	3	14,815		17,954		14,148		22,611
Derivatives:
Interest rate swaps	2	43,506		43,506		15,202		15,202
Interest rate lock and forward sales commitments	2,3	10,473		10,473		1,108		1,108
Liabilities:
Demand, interest checking and money market accounts	2	8,967,702		8,967,702		6,994,197		6,994,197
Regular savings	2	2,332,287		2,332,287		1,934,041		1,934,041
Certificates of deposit	2	915,352		921,332		1,120,403		1,117,921
FHLB advances	2	150,000		153,661		450,000		452,720
Other borrowings	2	176,983		176,983		118,474		118,474
Subordinated notes, net	3	98,114		98,114		—		—
Junior subordinated debentures	3	109,821		109,821		119,304		119,304
Derivatives:
Interest rate swaps	2	23,927		23,927		10,966		10,966
Interest rate lock and forward sales commitments	2	1,510		1,510		674		674

The Company measures and discloses certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (that is, not a forced liquidation or distressed sale). GAAP establishes a consistent framework for measuring fair value and disclosure requirements about fair value measurements. Among other things, the accounting standard requires the reporting entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s estimates for market assumptions. These two types of inputs create the following fair value hierarchy:

•Level 1 – Quoted prices in active markets for identical instruments. An active market is a market in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

•Level 2 – Observable inputs other than Level 1 including quoted prices in active markets for similar instruments, quoted prices in less active markets for identical or similar instruments, or other observable inputs that can be corroborated by observable market data.

•Level 3 – Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs from non-binding single dealer quotes not corroborated by observable market data.

The estimated fair value amounts of financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize at a future date. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. In addition, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and

numerous estimates that must be made given the absence of active secondary markets for certain financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values. Transfers between levels of the fair value hierarchy are deemed to occur at the end of the reporting period.

Items Measured at Fair Value on a Recurring Basis:

The following tables present financial assets and liabilities measured at fair value on a recurring basis and the level within the fair value hierarchy of the fair value measurements for those assets and liabilities as of September 30, 2020 and December 31, 2019 (in thousands):


	September 30, 2020
	Level 1		Level 2		Level 3		Total
Assets:
Securities—trading


Corporate bonds (Trust Preferred Securities)	$	—	$	—	$	23,276	$	23,276



Securities—available-for-sale
U.S. Government and agency obligations	—		169,913		—		169,913
Municipal bonds	—		272,408		—		272,408
Corporate bonds	—		55,971		—		55,971
Mortgage-backed or related securities	—		1,250,500		—		1,250,500
Asset-backed securities	—		9,592		—		9,592
	—		1,758,384		—		1,758,384

Loans held for sale	—		152,996		—		152,996
Equity securities	450,255		—		—		450,255

Derivatives
Interest rate swaps	—		43,506		—		43,506
Interest rate lock and forward sales commitments	—		2,019		8,454		10,473
	$	450,255	$	1,956,905	$	31,730	$	2,438,890

Liabilities:

Junior subordinated debentures	$	—	$	—	$	109,821	$	109,821
Derivatives
Interest rate swaps	—		23,927		—		23,927
Interest rate lock and forward sales commitments	—		1,510		—		1,510
	$	—	$	25,437	$	109,821	$	135,258


	December 31, 2019
	Level 1		Level 2		Level 3		Total
Assets:
Securities—trading


Corporate bonds (Trust Preferred Securities)	$	—	$	—	$	25,636	$	25,636




Securities—available-for-sale
U.S. Government and agency obligations	—		89,598		—		89,598
Municipal bonds	—		107,157		—		107,157
Corporate bonds	—		4,365		—		4,365
Mortgage-backed securities	—		1,342,311		—		1,342,311
Asset-backed securities	—		8,126		—		8,126

	—		1,551,557		—		1,551,557

Loans held for sale	—		199,397		—		199,397


Derivatives
Interest rate swaps	—		15,202		—		15,202
Interest rate lock and forward sales commitments	—		317		791		1,108
	$	—	$	1,766,473	$	26,427	$	1,792,900

Liabilities:

Junior subordinated debentures, net of unamortized deferred issuance costs	$	—	$	—	$	119,304	$	119,304
Derivatives
Interest rate swaps	—		10,966		—		10,966
Interest rate lock and forward sales commitments	—		674		—		674
	$	—	$	11,640	$	119,304	$	130,944

The following methods were used to estimate the fair value of each class of financial instruments above:

Securities: The estimated fair values of investment securities and mortgaged-backed securities are priced using current active market quotes, if available, which are considered Level 1 measurements. For most of the portfolio, matrix pricing based on the securities’ relationship to other benchmark quoted prices is used to establish the fair value. These measurements are considered Level 2. Due to the continued limited activity in the trust preferred markets that have limited the observability of market spreads for some of the Company’s TPS securities, management has classified these securities as a Level 3 fair value measure. Management periodically reviews the pricing information received from third-party pricing services and tests those prices against other sources to validate the reported fair values.

Loans Held for Sale: Fair values for residential mortgage loans held for sale are determined by comparing actual loan rates to current secondary market prices for similar loans. Fair values for multifamily loans held for sale are calculated based on discounted cash flows using as a discount rate a combination of market spreads for similar loan types added to selected index rates.

Mortgage Servicing Rights: Fair values are estimated based on an independent dealer analysis of discounted cash flows. The evaluation utilizes assumptions market participants would use in determining fair value including prepayment speeds, delinquency and foreclosure rates, the discount rate, servicing costs, and the timing of cash flows. The mortgage servicing portfolio is stratified by loan type and fair value estimates are adjusted up or down based on the serviced loan interest rates versus current rates on new loan originations since the most recent independent analysis.

Equity Securities: Equity securities at September 30, 2020 are invested in a money market mutual fund. The fair value of these securities are based on daily quoted market prices.

Junior Subordinated Debentures: The fair value of junior subordinated debentures is estimated using an income approach technique. The significant inputs included in the estimation of fair value are the credit risk adjusted spread and three month LIBOR. The credit risk adjusted spread represents the nonperformance risk of the liability. The Company utilizes an external valuation firm to validate the reasonableness of the credit risk adjusted spread used to determine the fair value. The junior subordinated debentures are carried at fair value which represents the estimated amount that would be paid to transfer these liabilities in an orderly transaction amongst market participants. Due to inactivity in the trust preferred markets that have limited the observability of market spreads, management has classified this as a Level 3 fair value measure.

Derivatives: Derivatives include interest rate swap agreements, interest rate lock commitments to originate loans held for sale and forward sales contracts to sell loans and securities related to mortgage banking activities. Fair values for these instruments, which generally change as a result of changes in the level of market interest rates, are estimated based on dealer quotes and secondary market sources.

Off-Balance Sheet Items: Off-balance sheet financial instruments include unfunded commitments to extend credit, including standby letters of credit, and commitments to purchase investment securities. The fair value of these instruments is not considered to be material.

Limitations: The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2020 and December 31, 2019. The factors used in the fair values estimates are subject to change subsequent to the dates the fair value estimates are completed, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

Assets and Liabilities Measured at Fair Value Using Significant Unobservable Inputs (Level 3):

The following table provides a description of the valuation technique, unobservable inputs, and qualitative information about the unobservable inputs for certain of the Company’s assets and liabilities classified as Level 3 and measured at fair value on a recurring and non-recurring basis at September 30, 2020 and December 31, 2019:


			Weighted Average Rate / Range
Financial Instruments	Valuation Techniques	Unobservable Inputs	September 30, 2020		December 31, 2019
Corporate bonds (TPS securities)	Discounted cash flows	Discount rate	4.73	%	5.91	%

Junior subordinated debentures	Discounted cash flows	Discount rate	4.73	%	5.91	%

Loans individually evaluated	Collateral valuations	Discount to appraised value	0.0% to 20.0%		0.0% to 20.0%
REO	Appraisals	Discount to appraised value	48.52	%	58.50	%

Interest rate lock commitments	Pricing model	Pull-through rate	87.05	%	89.61	%

TPS securities: Management believes that the credit risk-adjusted spread used to develop the discount rate utilized in the fair value measurement of TPS securities is indicative of the risk premium a willing market participant would require under current market conditions for instruments with similar contractual rates and terms and conditions and issuers with similar credit risk profiles and with similar expected probability of default. Management attributes the change in fair value of these instruments, compared to their par value, primarily to perceived general market adjustments to the risk premiums for these types of assets subsequent to their issuance.

Junior subordinated debentures: Similar to the TPS securities discussed above, management believes that the credit risk-adjusted spread utilized in the fair value measurement of the junior subordinated debentures is indicative of the risk premium a willing market participant would require under current market conditions for an issuer with Banner’s credit risk profile. Management attributes the change in fair value of the junior subordinated debentures, compared to their par value, primarily to perceived general market adjustments to the risk premiums for these types of liabilities subsequent to their issuance. Future contractions in the risk adjusted spread relative to the spread currently utilized to measure the Company’s junior subordinated debentures at fair value as of September 30, 2020, or the passage of time, will result in negative fair value adjustments. At September 30, 2020, the discount rate utilized was based on a credit spread of 450 basis points and three-month LIBOR of 23 basis points.

Interest rate lock commitments: The fair value of the interest rate lock commitments is based on secondary market sources adjusted for an estimated pull-through rate. The pull-through rate is based on historical loan closing rates for similar interest rate lock commitments. An increase or decrease in the pull-through rate would have a corresponding, positive or negative fair value adjustment.

The following tables provide a reconciliation of the assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the three and nine months ended September 30, 2020 and 2019 (in thousands):


	Three Months Ended						Nine Months Ended
	September 30, 2020						September 30, 2020
	Level 3 Fair Value Inputs						Level 3 Fair Value Inputs
	TPS Securities		Borrowings—Junior Subordinated Debentures		Interest rate lock and forward sales commitments		TPS Securities		Borrowings— Junior Subordinated Debentures		Interest rate lock and forward sales commitments
Beginning balance	$	23,239	$	109,613	$	5,816	$	25,636	$	119,304	$	791
Total gains or losses recognized
Assets gains (losses)	37		—		2,638		(2,360)		—		7,663
Liabilities losses (gains)	—		208		—		—		(9,483)		—



Ending balance at September 30, 2020	$	23,276	$	109,821	$	8,454	$	23,276	$	109,821	$	8,454

	Three Months Ended						Nine Months Ended
	September 30, 2019						September 30, 2019
	Level 3 Fair Value Inputs						Level 3 Fair Value Inputs
	TPS Securities		Borrowings—Junior Subordinated Debentures		Interest rate lock and forward sales commitments		TPS Securities		Borrowings— Junior Subordinated Debentures		Interest rate lock and forward sales commitments
Beginning balance	$	25,741	$	113,621	$	1,373	$	25,896	$	114,091	$	273
Total gains or losses recognized
Assets (losses) gains	(69)		—		33		(224)		—		1,133
Liabilities gains	—		(204)		—		—		(674)		—




Ending balance at September 30, 2019	$	25,672	$	113,417	$	1,406	$	25,672	$	113,417	$	1,406

Interest income and dividends from the TPS securities are recorded as a component of interest income. Interest expense related to the junior subordinated debentures is measured based on contractual interest rates and reported in interest expense. The change in fair value of the junior subordinated debentures, which represents changes in instrument specific credit risk, is recorded in other comprehensive income. See Note 14, Derivatives and Hedging, for detail on gains and losses on Level 3 interest rate lock commitments.

Items Measured at Fair Value on a Non-recurring Basis:

The following tables present financial assets measured at fair value on a non-recurring basis and the level within the fair value hierarchy of the fair value measurements for those assets as of September 30, 2020 and December 31, 2019 (in thousands):


	September 30, 2020
	Level 1		Level 2		Level 3		Total
Loans individually evaluated	$	—	$	—	$	12,131	$	12,131
REO	—		—		1,795		1,795


	December 31, 2019
	Level 1		Level 2		Level 3		Total
Impaired loans	$	—	$	—	$	14,853	$	14,853
REO	—		—		814		814

The following table presents the losses resulting from non-recurring fair value adjustments for the three and nine months ended September 30, 2020 and 2019 (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Loans individually evaluated	$	(492)	$	—	$	(2,492)	$	(425)
REO	—		—		—		—
Total loss from non-recurring measurements	$	(492)	$	—	$	(2,492)	$	(425)

Loans individually evaluated: Expected credit losses for loans evaluated individually are measured based on the present value of expected future cash flows discounted at the loan’s original effective interest rate or when the Bank determines that foreclosure is probable, the expected credit loss is measured based on the fair value of the collateral as of the reporting date, less estimated selling costs, as applicable. As a practical expedient, the Bank measures the expected credit loss for a loan using the fair value of the collateral, if repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the Bank’s assessment as of the reporting date. In both cases, if the fair value of the collateral is less than the amortized cost basis of the loan, the Bank will recognize an allowance as the difference between the fair value of the collateral, less costs to sell (if applicable), at the reporting date and the amortized cost basis of the loan. If the fair value of the collateral exceeds the amortized cost basis of the loan, any expected recovery added to the amortized cost basis will be limited to the amount previously charged-off by the subsequent changes in the expected credit losses for loans evaluated individually are included within the provision for credit losses in the same manner in which the expected credit loss initially was recognized or as a reduction in the provision that would otherwise be reported.

REO: The Company records REO (acquired through a lending relationship) at fair value on a non-recurring basis. Fair value adjustments on REO are based on updated real estate appraisals which are based on current market conditions. All REO properties are recorded at the lower of the estimated fair value of the real estate, less expected selling costs, or the carrying amount of the defaulted loans. From time to time, non-recurring fair value adjustments to REO are recorded to reflect partial write-downs based on an observable market price or current appraised value of property. Banner considers any valuation inputs related to REO to be Level 3 inputs. The individual carrying values of these assets are reviewed for impairment at least annually and any additional impairment charges are expensed to operations.

- 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.

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