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Note 9: Fair Value of Financial Instruments

12 Months Ended

Sep. 30, 2012

Note 9: Fair Value of Financial Instruments

Note 9: Fair Value of Financial Instruments

The Corporation adopted ASC 820, “Fair Value Measurements and Disclosures,” and elected the fair value option pursuant to ASC 825, “Financial Instruments” on loans originated for sale by PBM. ASC 820 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. ASC 825 permits entities to elect to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the “Fair Value Option”) at specified election dates. At each subsequent reporting date, an entity is required to report unrealized gains and losses on items in earnings for which the fair value option has been elected. The objective of the Fair Value Option is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.

The following table describes the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale at fair value.

		Aggregate
		Unpaid	Net
	Aggregate	Principal	Unrealized
	Fair Value	Balance	Gain
(In Thousands)
As of September 30, 2012:
Loans held for sale, measured at fair value	$307,319	$290,728	$16,591

As of June 30, 2012:
Loans held for sale, measured at fair value	$231,639	$220,849	$10,790

ASC 820-10-65-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” provides additional guidance for estimating fair value in accordance with ASC 820, “Fair Value Measurements,” when the volume and level of activity for the asset or liability have significantly decreased.

ASC 820 establishes a three-level valuation hierarchy that prioritizes inputs to valuation techniques used in fair value calculations. The three levels of inputs are defined 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.

Level 2

Observable inputs other than Level 1 such as: 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 can be corroborated to observable market data for substantially the full term of the asset or liability.

Level 3

Unobservable inputs for the asset or liability that use significant assumptions, including assumptions of risks. These unobservable assumptions reflect the Corporation’s estimate of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of pricing models, discounted cash flow models and similar techniques.

ASC 820 requires the Corporation to maximize the use of observable inputs and minimize the use of unobservable inputs. If a financial instrument uses inputs that fall in different levels of the hierarchy, the instrument will be categorized based upon the lowest level of input that is significant to the fair value calculation.

The Corporation’s financial assets and liabilities measured at fair value on a recurring basis consist of investment securities, loans held for sale at fair value, interest-only strips and derivative financial instruments; while non-performing loans, mortgage servicing assets (“MSA”) and real estate owned are measured at fair value on a nonrecurring basis.

Investment securities are primarily comprised of U.S. government agency MBS, U.S. government sponsored enterprise MBS and private issue CMO. The Corporation utilizes unadjusted quoted prices in active markets for identical securities for its fair value measurement of debt securities, quoted prices in active and less than active markets for similar securities for its fair value measurement of MBS and debt securities (Level 2), and broker price indications for similar securities in non-active markets for its fair value measurement of CMO (Level 3).

Derivative financial instruments are comprised of commitments to extend credit on loans to be held for sale, mandatory loan sale commitments, TBA-MBS trades and option contracts. The fair value of TBA-MBS trades is determined using quoted secondary-market prices (Level 2). The fair values of other derivative financial instruments are determined by quoted prices for a similar commitment or commitments, adjusted for the specific attributes of each commitment (Level 3).

Loans held for sale at fair value are primarily single-family loans. The fair value is determined, when possible, using quoted secondary-market prices such as mandatory loan sale commitments. If no such quoted price exists, the fair value of a loan is determined by quoted prices for a similar loan or loans, adjusted for the specific attributes of each loan (Level 2).

Non-performing loans are loans which are inadequately protected by the current net worth and paying capacity of the borrowers or of the collateral pledged. The non-performing loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. The fair value of a non-performing loan is determined based on an observable market price or current appraised value of the underlying collateral. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the borrower. For non-performing loans which are restructured loans, the fair value is derived from discounted cash flow analysis (Level 3), except those which are in the process of foreclosure or 90 days delinquent for which the fair value is derived from the appraised value of its collateral (Level 2). For other non-performing loans which are not restructured loans, the fair value is derived from historical experience and management estimates by loan type for which collectively evaluated allowances are assigned (Level 3), or the appraised value of its collateral for loans which are in the process of foreclosure or where borrowers file bankruptcy, for which the charge-off will occur when the loan becomes 60 days delinquent (Level 2). Non-performing loans are reviewed and evaluated on at least a quarterly basis for additional allowance and adjusted accordingly, based on the same factors identified above. This loss is not recorded directly as an adjustment to current earnings or other comprehensive income (loss), but rather as a component in determining the overall adequacy of the allowance for loan losses. These adjustments to the estimated fair value of non-performing loans may result in increases or decreases to the provision for loan losses recorded in current earnings.

The Corporation uses the amortization method for its MSA, which amortizes the MSA in proportion to and over the period of estimated net servicing income and assesses the MSA for impairment based on fair value at each reporting date. The fair value of MSA is calculated using the present value method; which includes a third party’s prepayment projections of similar instruments, weighted-average coupon rates and the estimated average life (Level 3).

The rights to future income from serviced loans that exceed contractually specified servicing fees are recorded as interest-only strips. The fair value of interest-only strips is calculated using the same assumptions that are used to value the related MSA (Level 3).

The fair value of real estate owned is derived from the lower of the appraised value at the time of foreclosure or the listing price, not including disposition costs (Level 2).

The Corporation’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 Corporation’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.

The following fair value hierarchy table presents information about the Corporation’s assets measured at fair value on a recurring basis:

	Fair Value Measurement at September 30, 2012 Using:
	Level 1	Level 2	Level 3	Total
(In Thousands)
Assets:
Investment securities:
U.S. government agency MBS	$-	$11,939	$-	$11,939
U.S. government sponsored enterprise MBS	-	9,012	-	9,012
Private issue CMO	-	-	1,198	1,198
Investment securities	-	20,951	1,198	22,149

Loans held for sale, at fair value	-	307,319	-	307,319
Interest-only strips	-	-	117	117

Derivative assets:
Commitments to extend credit on loans to be held for sale	-	-	8,373	8,373
Mandatory loan sale commitments	-	-	83	83
TBA MBS trades	-	316	-	316
Option contracts	-	-	65	65
Derivative assets	-	316	8,521	8,837
Total assets	$-	$328,586	$9,836	$338,422

Liabilities:
Derivative liabilities:
Commitments to extend credit on loans to be held for sale	$-	$-	$3	$3
Mandatory loan sale commitments	-	-	1,197	1,197
TBA MBS trades	-	5,176	-	5,176
Derivative liabilities	-	5,176	1,200	6,376
Total liabilities	$-	$5,176	$1,200	$6,376

	Fair Value Measurement at June 30, 2012 Using:
	Level 1	Level 2	Level 3	Total
(In Thousands)
Assets:
Investment securities:
U.S. government agency MBS	$-	$12,314	$-	$12,314
U.S. government sponsored enterprise MBS	-	9,342	-	9,342
Private issue CMO	-	-	1,242	1,242
Investment securities	-	21,656	1,242	22,898

Loans held for sale, at fair value	-	231,639	-	231,639
Interest-only strips	-	-	130	130

Derivative assets:
Commitments to extend credit on loans to be held for sale	-	-	3,998	3,998
Mandatory loan sale commitments	-	-	38	38
TBAMBS trades	-	121	-	121
Option contracts	-	-	36	36
Derivative assets	-	121	4,072	4,193
Total assets	$-	$253,416	$5,444	$258,860

Liabilities:
Derivative liabilities:
Commitments to extend credit on loans to be held for sale	$-	$-	$17	$17
Mandatory loan sale commitments	-	-	201	201
TBAMBS trades	-	1,274	-	1,274
Derivative liabilities	-	1,274	218	1,492
Total liabilities	$-	$1,274	$218	$1,492

The following is a reconciliation of the beginning and ending balances during the periods shown of recurring fair value measurements recognized in the Condensed Consolidated Statements of Financial Condition using Level 3 inputs:

	Fair Value Measurement
	Using Significant Other Unobservable Inputs
	(Level 3)
			Loan	Manda-
	Private	Interest-	Commit-	tory
	Issue	Only	ments to	Commit-	Option
	CMO	Strips	originate ⁽¹⁾	ments⁽²⁾	Contracts	Total
(In Thousands)
Beginning balance at July 1, 2012	$1,242	$130	$3,981	$(163)	$36	$5,226
Total gains or losses (realized/unrealized):
Included in earnings	-	-	(3,981)	163	(36)	(3,854)
Included in other comprehensive income (loss)	1	(13)	-	-	-	(12)
Purchases	-	-	-	(1,114)	65	(1,049)
Issuances	-	-	8,370	-	-	8,370
Settlements	(45)	-	-	-	-	(45)
Transfers in and/or out of Level 3	-	-	-	-	-	-
Ending balance at September 30, 2012	$1,198	$117	$8,370	$(1,114)	$65	$8,636

Beginning balance at July 1, 2011	$1,367	$200	$638	$403	$99	$2,707
Total gains or losses (realized/unrealized):
Included in earnings	-	-	(638)	(403)	(99)	(1,140)
Included in other comprehensive loss	(42)	(33)	-	-	-	(75)
Purchases	-	-	-	(130)	142	12
Issuances	-	-	3,462	-	-	3,462
Settlements	(37)	-	-	-	-	(37)
Transfers in and/or out of Level 3	-	-	-	-	-	-
Ending balance at September 30, 2011	$1,288	$167	$3,462	$(130)	$142	$4,929

⁽¹⁾Consists of commitments to extend credit on loans to be held for sale.

⁽²⁾Consists of mandatory loan sale commitments.

The following fair value hierarchy table presents information about the Corporation’s assets measured at fair value at the dates indicated on a nonrecurring basis:

	Fair Value Measurement at September 30, 2012 Using:
	Level 1	Level 2	Level 3	Total
(In Thousands)
Non-performing loans ⁽¹⁾	$-	$7,959	$21,582	$29,541
Mortgage servicing assets	-	-	269	269
Real estate owned ⁽¹⁾	-	5,675	-	5,675
Total	$-	$13,634	$21,851	$35,485

	Fair Value Measurement at June 30, 2012 Using:
	Level 1	Level 2	Level 3	Total
(In Thousands)
Non-performing loans ⁽¹⁾	$-	$10,335	$25,006	$35,341
Mortgage servicing assets	-	-	227	227
Real estate owned ⁽¹⁾	-	5,976	-	5,976
Total	$-	$16,311	$25,233	$41,544

⁽¹⁾ Amounts are based on collateral value as a practical expedient for fair value, and exclude estimated selling costs where determined.

The following table presents additional information about valuation techniques and inputs used for assets and liabilities, including derivative financial instruments, which are measured at fair value and categorized within Level 3 as of September 30, 2012 (dollars in thousands):

					Impact to
					Valuation
	Fair Value			Range (1)	from
	As of	Valuation	Unobservable	(Weighted	an Increase
	September 30, 2012	Techniques	Inputs	Average)	in Inputs (2)

Assets:
Securities available-for sale
Private issue CMO	$1,198	Discounted cash flow	Probability of default	70.0% – 110.0% (100.2%) of par	Increase
			Loss severity	(36.7%)	Decrease
			Prepayment speed	4.1% - 11.7% (6.7%)	Decrease
Non-performing loans	$21,582	Discounted cash flow or aggregated pooling method	Default rates	-31.30%	Decrease
			Loss severity	8.5%	Decrease

MSA	$269	Discounted cash flow	Prepayment speed (CPR)	6.7% - 60.0% (33.9%)	Decrease

Interest-only strips	$117	Discounted cash flow	Prepayment speed (CPR)	3.5% - 48.3% (28.4%)	Decrease
	--	--	Discount rate	9.0%	Decrease

Commitments to extend credit on loans to be held for sale	$8,373	Relative value analysis	TBA-MBS broker quotes	98.9% - 105.4% (102.2%) of par	Decrease
	--	--	Fall-out ratio (3)	22% - 36% (36%)	Decrease

Mandatory loan sale commitments	$83	Relative value analysis	Investor quotes	101.8% - 107.3% (104.2%) of par	Decrease
	--	--	TBA-MBS broker quotes	106.6% - 109.2%	Decrease
	--	--	Roll-forward costs (4)	(106.7%) of par 0.00%	Decrease
Put options	$65	Relative value analysis	Broker quotes	106.5% - 107.3% (107.1%) of par	Increase

Liabilities:

Commitments to extend credit on loans to be held for sale	$3	Relative value analysis	TBA-MBS broker quotes	99.6% - 102.5% (101.9%) of par	Decrease
	--	--	Fall-out ratio (3)	22% - 36% (36%)	Decrease

Mandatory loan sale commitments	$1,197	Relative value analysis	Investor quotes	102.4% - 107.4% (106.2%) of par	Decrease
	--	--	TBA-MBS broker quotes	105.2% - 110.1% (108.1%) of par	Decrease
	--	--	Roll-forward costs (4)	0.00%	Decrease

⁽¹⁾The range is based on the historical estimated fair values and management estimates.

⁽²⁾Unless otherwise noted, this column represents the directional change in the fair value of the Level 3 investments that would result from an increase to the corresponding unobservable input. A decrease to the unobservable input would have the opposite effect. Significant changes in these inputs in isolation could result in significantly higher or lower fair value measurements.

⁽³⁾The percentage of commitments to extend credit on loans to be held for sale which management has estimated may not fund.

⁽⁴⁾An estimated cost to roll forward the mandatory loan sale commitments which management has estimated may not be delivered to the corresponding investors in a timely manner.

The significant unobservable inputs used in the fair value measurement of the Corporation’s assets and liabilities include the followings: CMO offered quotes, prepayment speeds, discount rates, MBS – TBA quotes, fallout ratios, investor quotes and roll-forward costs, among others. Significant increases or decreases in any of these inputs in isolation could result in significantly lower or higher fair value measurement. The various unobservable inputs used to determine valuations may have similar or diverging impacts on valuation.

The carrying amount and fair value of the Corporation’s other financial instruments as of September 30, 2012 and June 30, 2012 are as follows (dollars in thousands):

	September 30, 2012
	Carrying	Fair
	Amount	Value	Level 1	Level 2	Level 3
Financial assets:
Cash and cash equivalents	$98,489	$98,489	$98,489	-	-
Investment securities	$22,149	$22,149	-	$20,951	$1,198
Loans held for investment, net	$776,844	$778,074	-	-	$778,074
Loans held for sale, at fair value	$307,319	$307,319	-	$307,319	-
FHLB – San Francisco stock	$21,107	$21,107	-	$21,107	-

Financial liabilities:
Deposits	$956,815	$944,150	-	-	$944,150
Borrowings	$126,533	$136,087	-	-	$136,087

	June 30, 2012
	Carrying	Fair
	Amount	Value	Level 1	Level 2	Level 3
Financial assets:
Cash and cash equivalents	$145,136	$145,136	$145,136	-	-
Investment securities	$22,898	$22,898	-	$21,656	$1,242
Loans held for investment, net	$796,836	$801,081	-	-	$801,081
Loans held for sale, at fair value	$231,639	$231,639	-	$231,639	-
FHLB – San Francisco stock	$22,255	$22,255	-	$22,255	-

Financial liabilities:
Deposits	$961,411	$948,985	-	-	$948,985
Borrowings	$126,546	$134,936	-	-	$134,936

Cash and cash equivalents: The carrying amount of these financial assets approximates the fair value.

Loans held for investment: For loans that reprice frequently at market rates, the carrying amount approximates the fair value. For fixed-rate loans, the fair value is determined by either (i) discounting the estimated future cash flows of such loans over their estimated remaining contractual maturities using a current interest rate at which such loans would be made to borrowers, or (ii) quoted market prices. The allowance for loan losses is subtracted as an estimate of the underlying credit risk.

FHLB – San Francisco stock: The carrying amount reported for FHLB – San Francisco stock approximates fair value. When redeemed, the Corporation will receive an amount equal to the par value of the stock.

Deposits: The fair value of time deposits is estimated using a discounted cash flow calculation. The discount rate is based upon rates currently offered for deposits of similar remaining maturities. The fair value of transaction accounts (checking, money market and savings accounts) is based on management estimates, consistent with current market conditions.

Borrowings: The fair value of borrowings has been estimated using a discounted cash flow calculation. The discount rate on such borrowings is based upon rates currently offered for borrowings of similar remaining maturities.

The Corporation has various processes and controls in place to ensure that fair value is reasonably estimated. The Corporation generally determines fair value of their Level 3 assets and liabilities by using internally developed models which primarily utilize discounted cash flow techniques and prices obtained from independent management services or brokers. The Corporation performs due diligence procedures over third-party pricing service providers in order to support their use in the valuation process. The fair values of investment securities, commitments to extend credit on loans held for sale, mandatory commitments and option contracts are determined from the independent management services or brokers; while the fair value of MSA and interest only strips are determined using the internally developed models which are based on discounted cash flow analysis. The fair value of non-performing loans is determined by calculating discounted cash flows, collectively evaluated allowances or collateral value, less selling costs.

While the Corporation believes its valuation methods 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. During the quarter ended September 30, 2012, there were no significant changes to the Corporation’s valuation techniques that had, or are expected to have, a material impact on its consolidated financial position or results of operations.