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Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2020

The fair value of an asset or liability is the exchange price that would be received to sell that asset or paid to transfer that liability (exit price) in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach, and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC Topic 825 requires disclosure of the fair value of financial assets and financial liabilities, including both those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis and a non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value are discussed below.

In accordance with accounting guidance, the Company groups its financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described as follows:

Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2 - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, prepayment speeds, volatilities, etc.) or model-based valuation techniques where all significant assumptions are observable, either directly or indirectly, in the market.

Level 3 - Valuation is generated from model-based techniques where one or more significant inputs are not observable, either directly or indirectly, in the market. These unobservable assumptions reflect the Company’s own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques may include use of matrix pricing, discounted cash flow models, and similar techniques.

Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented. Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent limitations in any estimation technique.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Management maximizes the use of observable inputs and attempts to minimize the use of unobservable inputs when determining fair value measurements. Estimated fair values are disclosed for financial instruments for which it is practicable to estimate fair value. These estimates are made at a specific point in time based on relevant market data and information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following is a description of both the general and specific valuation methodologies used to measure financial assets and liabilities on a recurring basis, as well as the general classification of these instruments pursuant to the fair value hierarchy.

Investment securities – Investment securities are generally valued based upon quotes obtained from independent third-party pricing services, which use evaluated pricing applications and model processes. Observable market inputs, such as, benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data are considered as part of the evaluation. The inputs are related directly to the security being evaluated, or indirectly to a similarly situated security. Market assumptions and market data are utilized in the valuation models. The Company reviews the market prices provided by the third-party pricing service for reasonableness based on the Company’s understanding of the market place and credit issues related to the securities. The Company has not made any adjustments to the market quotes provided by them and, accordingly, the Company categorized its investment portfolio within Level 2 of the fair value hierarchy.

Interest rate swaps – The Company originates a variable rate loan and enters into a variable-to-fixed interest rate swap with the customer. The Company also enters into an offsetting swap with a correspondent bank. These back-to-back swap agreements are intended to offset each other and allow the Company to originate a variable rate loan, while providing a contract for fixed interest payments for the customer. The net cash flow for the Company is equal to the interest income received from a variable rate loan originated with the customer. The fair value of these derivatives is based on a market standard discounted cash flow approach. Due to the observable nature of the majority of inputs used in deriving the fair value of these derivative contracts, the valuation of derivatives is classified as Level 2.

Equity Warrant assets – The Company acquired equity warrant assets as a result of acquisition of Opus. Opus received equity warrant assets through its lending activities as part of loan origination fees. The warrants provide the Bank the right to purchase a specific number of equity shares of the underlying company’s equity at a certain price before expiration and contain net settlement terms qualifying as derivatives under ASC Topic 815. The Company has chosen to account for equity warrants under the fair value option, an irrevocable election under which the changes to the fair value of these assets are recognized in earnings. The fair value of equity warrant assets is determined using a Black-Scholes option pricing model and are classified as Level 3 with the fair value hierarchy due to the extent of unobservable inputs. The key assumptions used in determining the fair value include the exercise price of the warrants, valuation of the underlying entity's outstanding stock, expected term, risk-free interest rate, marketability discount for private company warrants, and price volatility.

The following fair value hierarchy table presents information about the Company’s financial assets and liabilities measured at fair value on a recurring basis at the dates indicated:


	June 30, 2020
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Total Fair Value
	(Dollars in thousands)
Financial assets
Investment securities available-for-sale:
U.S. Treasury	$	—	$	32,870	$	—	$	32,870
Agency	—		339,990		—		339,990
Corporate	—		273,999		—		273,999
Municipal bonds	—		461,335		—		461,335
Collateralized mortgage obligations	—		384,739		—		384,739
Mortgage-backed securities	—		843,133		—		843,133
Total securities available-for-sale	$	—	$	2,336,066	$	—	$	2,336,066

Derivative assets:
Interest rate swaps	$	—	$	15,707	$	—	$	15,707
Equity warrants	—		—		1,952		1,952
Total derivative assets	$	—	$	15,707	$	1,952	$	17,659

Financial liabilities
Derivative liabilities	$	—	$	16,017	$	—	$	16,017


	December 31, 2019
	Fair Value Measurement Using
	Level 1		Level 2		Level 3		Total Fair Value
	(Dollars in thousands)
Financial assets
Investment securities available-for-sale:
U.S. Treasury	$	—	$	63,555	$	—	$	63,555
Agency	—		246,358		—		246,358
Corporate	—		151,353		—		151,353
Municipal bonds	—		397,298		—		397,298
Collateralized mortgage obligations	—		9,984		—		9,984
Mortgage-backed securities	—		499,836		—		499,836
Total securities available-for-sale	$	—	$	1,368,384	$	—	$	1,368,384

Derivative assets	$	—	$	2,103	$	—	$	2,103

Financial liabilities
Derivative liabilities	$	—	$	2,103	$	—	$	2,103

The following table is a reconciliation of the fair value of the equity warrants that are classified as Level 3 and measured on a recurring basis:


	June 30, 2020
	(Dollars in thousands)
Beginning Balance	$	5,162
Change in fair value ⁽¹⁾	(3)
Sales	(3,207)
Ending balance	$	1,952

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⁽¹⁾ The changes in fair value are included in other income on the consolidated statement of income.

The following table presents quantitative information about level 3 of fair value measurements for assets measured at fair value on a recurring basis at June 30, 2020.

June 30, 2020

Range

Fair Value

Valuation Technique(s)

Unobservable Input(s)

Min

Max

Weighted Average

(Dollars in thousands)

Equity warrants

1,952

Black-Scholes
option pricing
model

Volatility
Risk free interest rate
Marketability discount

30.00% 0.16% 6.00%

41.25%

0.28%

33.00%

31.33%

20.00%

13.67%

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Individually evaluated Loans (impaired loans prior to adoption of ASC 326) – A loan is individually evaluated for expected credit losses when it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Individually evaluated loans is measured based on the fair value of the underlying collateral or the discounted expected future cash flows. Collateral generally consists of accounts receivable, inventory, fixed assets, real estate and cash. The Company measures impairment on all nonaccrual loans for which it has reduced the principal balance to the value of the underlying collateral less the anticipated selling cost.

Other Real Estate Owned – OREO is initially recorded at the fair value less estimated costs to sell at the date of transfer. This amount becomes the property’s new basis. Any fair value adjustments based on the property’s fair value less estimated costs to sell at the date of acquisition are charged to the allowance for credit losses.

The fair value of individually evaluated loans and other real estate owned were determined using Level 3 assumptions, and represents individually evaluated loan and other real estate owned balances for which a specific reserve has been established or on which a write down has been taken. For real estate loans, generally, the Company obtains third party appraisals (or property valuations) and/or collateral audits in conjunction with internal analysis based on historical experience on its individually evaluated loans and other real estate owned to determine fair value. In determining the net realizable value of the underlying collateral for individually evaluated loans, the Company will then discount the valuation to cover both market price fluctuations and selling costs, typically ranging from 7% to 10% of the collateral value, that the Company expected would be incurred in the event of foreclosure. In addition to the discounts taken, the Company’s calculation of net realizable value considered any other senior liens in place on the underlying collateral. For non-real estate loans, fair value of the loan’s collateral may be determined using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions and management’s expertise and knowledge of the client and client’s business.

At June 30, 2020, the Company’s individually evaluated collateral dependent loans were evaluated based on the fair value of their underlying collateral based upon the most recent appraisals available to management. The Company completed partial charge-offs on certain individually evaluated loans based on recent real estate or property appraisals and released the related specific reserves during the six months ended June 30, 2020.

The following table presents our assets measured at fair value on a nonrecurring basis at June 30, 2020 and December 31, 2019.


	June 30, 2020
	Level 1		Level 2		Level 3		Total Fair Value
	(Dollars in thousands)
Financial assets
Collateral dependent loans	$	—	$	—	$	3,904	$	3,904
Other real estate owned	—		—		260		260
Total assets	$	—	$	—	$	4,164	$	4,164


	December 31, 2019
	Level 1		Level 2		Level 3		Total Fair Value
	(Dollars in thousands)
Financial assets
Impaired loans	$	—	$	—	$	2,257	$	2,257

The following table presents quantitative information about level 3 of fair value measurements for assets measured at fair value on a nonrecurring basis at June 30, 2020 and December 31, 2019.


	June 30, 2020
					Range
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Min		Max	Weighted Average
	(Dollars in thousands)
Investor loans secured by real estate
CRE non-owner-occupied	$	322	Fair value of collateral	Collateral discount and cost to sell	10.00%		10.00%	10.00%


SBA secured by real estate ⁽¹⁾	593		Fair value of collateral	Collateral discount and cost to sell	10.00%		10.00%	10.00%

Business loans secured by real estate


SBA secured by real estate ⁽²⁾	247		Fair value of collateral	Collateral discount and cost to sell	10.00%		10.00%	10.00%

Commercial loans
Commercial and industrial	312		Fair value of collateral	Collateral discount and cost to sell	5.00%	5.00%	5.00%	5.00%
Franchise non-real estate secured	2,428		Fair value of collateral	Collateral discount and cost to sell	—%		10.00%	10.00%
SBA non-real estate secured	2		Fair value of collateral	Collateral discount and cost to sell	7.00%		7.00%	7.00%





Total individually evaluated loans	3,904
Other real estate owned	260		Fair value of property	Cost to sell	10.00%		10.00%	10.00%
Total assets	$	4,164


	December 31, 2019
					Range
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Min	Max	Weighted Average
	(Dollars in thousands)
Investor loans secured by real estate
CRE non-owner-occupied	$	569	Fair value of collateral	Collateral discount and cost to sell	10.00%	10.00%	10.00%


SBA secured by real estate ⁽¹⁾	408		Fair value of collateral	Collateral discount and cost to sell	10.00%	10.00%	10.00%

Business loans secured by real estate


SBA secured by real estate ⁽²⁾	140		Fair value of collateral	Collateral discount and cost to sell	7.00%	10.00%	7.81%

Commercial loans


SBA non-real estate secured	1,140		Fair value of collateral	Collateral discount and cost to sell	7.00%	63.00%	15.33%





Total individually evaluated loans	$	2,257

______________________________

⁽¹⁾ SBA loans that are collateralized by hotel/motel real property.

⁽²⁾ SBA loans that are collateralized by real property other than hotel/motel real property.

Fair Values of Financial Instruments

The fair value estimates presented herein are based on pertinent information available to management as of the dates indicated, representing an exit price.


	At June 30, 2020
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(Dollars in thousands)
Assets
Cash and cash equivalents	$	1,341,730	$	1,341,730	$	—	$	—	$	1,341,730
Interest-bearing time deposits with financial institutions	2,845		2,845		—		—		2,845
Investments held-to-maturity	32,557		—		34,179		—		34,179
Investment securities available-for-sale	2,336,066		—		2,336,066		—		2,336,066
Loans held for sale	1,007		—		1,081		—		1,081
Loans held for investment, net	15,082,884		—		—		15,308,998		15,308,998

Derivative assets	17,659		—		15,707		1,952		17,659
Accrued interest receivable	78,408		78,408		—		—		78,408

Liabilities
Deposit accounts	$	16,976,693	$	15,057,613	$	1,926,624	$	—	$	16,984,237
FHLB advances	41,006		—		41,700		—		41,700

Subordinated debentures	501,375		—		565,772		—		565,772
Derivative liabilities	16,017		—		16,017		—		16,017
Accrued interest payable	6,991		6,991		—		—		6,991


	At December 31, 2019
	Carrying Amount		Level 1		Level 2		Level 3		Estimated Fair Value
	(Dollars in thousands)
Assets
Cash and cash equivalents	$	326,850	$	326,850	$	—	$	—	$	326,850
Interest-bearing time deposits with financial institutions	2,708		2,708		—		—		2,708
Investments held-to-maturity	37,838		—		38,760		—		38,760
Investment securities available-for-sale	1,368,384		—		1,368,384		—		1,368,384
Loans held for sale	1,672		—		1,821		—		1,821
Loans held for investment, net	8,722,311		—		—		8,691,019		8,691,019
Derivative assets	2,103		—		2,103		—		2,103
Accrued interest receivable	39,442		39,442		—		—		39,442

Liabilities
Deposit accounts	$	8,898,509	$	7,850,667	$	1,048,583	$	—	$	8,899,250
FHLB advances	517,026		—		517,291		—		517,291
Other borrowings	—		—		—		—		—
Subordinated debentures	215,145		—		237,001		—		237,001
Derivative liabilities	2,103		—		2,103		—		2,103
Accrued interest payable	2,686		2,686		—		—		2,686

The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

- 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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