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 at the dates indicated between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale at fair value.



(In Thousands)	Aggregate Fair Value		Aggregate Unpaid Principal Balance		Net Unrealized (Loss) Gain
As of June 30, 2013:
Loans held for sale, measured at fair value	$	188,050	$	188,545	$	(495	)

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, 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 Corporation 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 relative value analysis: 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). For non-performing commercial real estate loans, the fair value is derived from the appraised value of its collateral (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, net of estimated 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 at the dates indicated about the Corporation’s assets measured at fair value on a recurring basis:



	Fair Value Measurement at June 30, 2013 Using:
(In Thousands)	Level 1		Level 2		Level 3		Total
Assets:
Investment securities:
U.S. government agency MBS	$	—	$	10,816	$	—	$	10,816
U.S. government sponsored enterprise MBS	—		7,675		—		7,675
Private issue CMO	—		—		1,019		1,019
Investment securities	—		18,491		1,019		19,510

Loans held for sale, at fair value	—		188,050		—		188,050
Interest-only strips	—		—		98		98

Derivative assets:
Commitments to extend credit on loans to be held for sale	—		—		1,338		1,338
Mandatory loan sale commitments	—		—		405		405
TBA MBS trades	—		7,251		—		7,251
Option contracts	—		—		589		589
Derivative assets	—		7,251		2,332		9,583
Total assets	$	—	$	213,792	$	3,449	$	217,241

Liabilities:
Derivative liabilities:
Commitments to extend credit on loans to be held for sale	$	—	$	—	$	2,370	$	2,370
Mandatory loan sale commitments	—		—		322		322
TBA MBS trades	—		529		—		529
Derivative liabilities	—		529		2,692		3,221
Total liabilities	$	—	$	529	$	2,692	$	3,221



	Fair Value Measurement at June 30, 2012 Using:
(In Thousands)	Level 1		Level 2		Level 3		Total
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 Consolidated Statements of Financial Condition using Level 3 inputs:



	Fair Value Measurement Using Significant Other Unobservable Inputs (Level 3)
(In Thousands)	Private Issue CMO			Interest- Only Strips			Loan Commit- ments to originate ⁽¹⁾			Manda- tory Commit- ments ⁽²⁾			Option Contracts			Total
Beginning balance at June 30, 2012	$	1,242		$	130		$	3,981		$	(163	)	$	36		$	5,226
Total gains or losses (realized/unrealized):
Included in earnings	—			—			(68,123		)	156			214			(67,753		)
Included in other comprehensive loss	(16		)	(31		)	—			—			—			(47		)
Purchases	—			—			—			83			1,084			1,167
Issuances	—			—			13,995			—			—			13,995
Settlements	(207		)	(1		)	49,115			7			(745		)	48,169
Transfers in and/or out of Level 3	—			—			—			—			—			—
Ending balance at June 30, 2013	$	1,019		$	98		$	(1,032	)	$	83		$	589		$	757


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


⁽²⁾	Consists of mandatory loan sale commitments.



	Fair Value Measurement Using Significant Other Unobservable Inputs (Level 3)
(In Thousands)	Private Issue CMO			Interest- Only Strips			Loan Commit- ments to originate ⁽¹⁾			Manda- tory Commit- ments ⁽²⁾			Option Contracts			Total
Beginning balance at June 30, 2011	$	1,367		$	200		$	638		$	403		$	99		$	2,707
Total gains or losses (realized/unrealized):
Included in earnings	—			—			39,309			(932		)	(360		)	38,017
Included in other comprehensive loss	29			(70		)	—			—			—			(41		)
Purchases	—			—			—			(163		)	305			142
Issuances	—			—			(3,257		)	—			—			(3,257		)
Settlements	(154		)	—			(32,709		)	529			(8		)	(32,342		)
Transfers in and/or out of Level 3	—			—			—			—			—			—
Ending balance at June 30, 2012	$	1,242		$	130		$	3,981		$	(163	)	$	36		$	5,226


⁽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 June 30, 2013 Using:
(In Thousands)	Level 1		Level 2		Level 3		Total
Non-performing loans	$	—	$	11,650	$	10,032	$	21,682
Mortgage servicing assets	—		—		174		174
Real estate owned, net	—		2,296		—		2,296
Total	$	—	$	13,946	$	10,206	$	24,152



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

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 June 30, 2013:



(Dollars In Thousands)	Fair Value As of June 30, 2013		Valuation Techniques	Unobservable Inputs	Range ⁽¹⁾ (Weighted Average)	Impact to Valuation from an Increase in Inputs ⁽²⁾

Assets:

Securities available-for sale: Private issue CMO	$	1,019	Discounted cash flow	Probability of default Loss severity Prepayment speed	0.6% – 1.1% (0.7%) 35.4% - 37.6% (37.3%) 4.2% – 13.5% (6.2%)	Decrease Decrease Decrease

Non-performing loans	$	1,237	Discounted cash flow	Default rates	0.0% - 30.0% (23.8%)	Decrease
Non-performing loans	$	8,795	Relative value analysis	Loss severity	15.0% - 60.0% (20.1%)	Decrease

Mortgage servicing assets	$	174	Discounted cash flow	Prepayment speed (CPR) Discount rate	25.2% - 60.0% (37.1%) 9.0% - 10.5% (9.2%)	Decrease Decrease

Interest-only strips	$	98	Discounted cash flow	Prepayment speed (CPR) Discount rate	0.0% - 36.3% (23.9%) 9.0%	Decrease Decrease

Commitments to extend credit on loans to be held for sale	$	1,338	Relative value analysis	TBA MBS broker quotes Fall-out ratio ⁽³⁾	97.6% – 104.5% (101.5%) of par 19.7% - 23.9% (23.6%)	Decrease Decrease

Mandatory loan sale commitments	$	405	Relative value analysis	Investor quotes TBA MBS broker quotes Roll-forward costs ⁽⁴⁾	97.1% of par 95.1% - 104.1% (100.2%) of par 0.0058%	Decrease Decrease Decrease

Option contracts	$	589	Relative value analysis	Broker quotes	97.7% of par	Increase

Liabilities:

Commitments to extend credit on loans to be held for sale	$	2,370	Relative value analysis	TBA MBS broker quotes Fall-out ratio ⁽³⁾	98.1% – 104.3% (101.3%) of par 19.7% - 23.9% (23.6%)	Decrease Decrease

Mandatory loan sale commitments	$	322	Relative value analysis	Investor quotes TBA MBS broker quotes Roll-forward costs ⁽⁴⁾	99.1% of par 97.5% - 104.5% (99.3%) of par 0.0058%	Decrease Decrease 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 following: CMO offered quotes, prepayment speeds, discount rates, TBA MBS 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 June 30, 2013 and 2012 were as follows:



	June 30, 2013
(In Thousands)	Carrying Amount		Fair Value		Level 1	Level 2		Level 3
Financial assets:
Loans held for investment, net	$	748,397	$	742,256	—	—		$	742,256
FHLB – San Francisco stock	$	15,273	$	15,273	—	$	15,273	—

Financial liabilities:
Deposits	$	923,010	$	903,654	—	—		$	903,654
Borrowings	$	106,491	$	110,404	—	—		$	110,404



	June 30, 2012
(In Thousands)	Carrying Amount		Fair Value		Level 1	Level 2		Level 3
Financial assets:
Loans held for investment, net	$	796,836	$	801,081	—	—		$	801,081
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

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, relative value analysis 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 year ended June 30, 2013, 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.