19. Fair Value Measurement

On January 1, 2010, the Company elected to account for held for sale residential mortgage loans originated by Cole Taylor Mortgage at fair value under the fair value option in accordance with ASC 825—Financial Instruments. When the Company began to retain mortgage servicing rights ("MSR") in 2011, an election was made to account for these rights under the fair value option. In addition, any purchased MSRs are accounted for under the fair value option. The Company has not elected the fair value option for any other financial asset or liability.

In accordance with FASB ASC 820, the Company groups 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. These levels are defined as follows.

Level 1 – Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 – Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3 – Significant unobservable inputs that reflect an entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate fair values:

Available for sale investment securities:

The Company obtains fair value measurements from an independent pricing service, when available. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current ratings from credit rating agencies and the bond's terms and conditions, among other things. The fair value measurements are compared to another independent source on a quarterly basis to review for reasonableness. In addition, the Company reviews the third party valuation methodology on a periodic basis. The Company has determined that these valuations are classified in Level 2 of the fair value hierarchy. When the independent pricing service does not have fair value measurements available for a security, the Company has set the fair value to equal the present value of the expected cash flows. The Company has determined that these valuations are classified in Level 3 of the fair value hierarchy.

The Company does not have subprime loans in its mortgage related investment securities portfolio. As of December 31, 2011, the Company had $1.19 billion of mortgage related investment securities which consisted of mortgage-backed securities and collateralized mortgage obligations. Of the total mortgage related investment securities, $1.18 billion, or 99.6%, were issued by government sponsored enterprises, such as Ginnie Mae, Fannie Mae, and Freddie Mac. In comparison, of the $1.16 billion of mortgage related investment securities at December 31, 2010, $1.15 billion, or 99.4%, were issued by government sponsored enterprises. The mortgage related portfolio also includes $4.9 million of private-label mortgage related securities at December 31, 2011 that has received heightened monitoring because the Company believes the fair values of these securities have been impacted by illiquidity in the market place. While none of these securities contain subprime mortgage loans, the portfolio does include Alt-A loans, adjustable rate mortgages with initial interest only periods, and loans that are secured by collateral in geographic areas adversely impacted by the housing downturn. While the fair value of these securities has been impacted by market illiquidity, the Company does not modify the fair value determined by the independent pricing service, but takes additional steps to review for other-than-temporary impairment. See Note 3 –"Investment Securities" for additional details of the evaluation of other-than-temporary impairment.

Loans held for sale:

At December 31, 2011, loans held for sale included $186.0 million of residential mortgage loans, that were originated by Cole Taylor Mortgage and for which the Company has elected to account for on a recurring basis under the fair value option.

In prior periods, the Company had certain residential mortgage loans that it acquired in a bulk purchase transaction and nonaccrual commercial loans classified as held for sale. These loans were recorded at the lower of cost or fair value and were recorded at fair value on a nonrecurring basis.

For all residential mortgage loans held for sale, the fair value is based on quoted market prices for similar assets in active markets and is classified in Level 2 of the fair value hierarchy. The fair value of the commercial loans was determined based on the estimated net contracted sales price, less cost to sell and was classified in Level 2 of the fair value hierarchy.

Loans:

The Company does not record loans at their fair value on a recurring basis except for $5.1 million of mortgage loans originated by Cole Taylor Mortgage and later transferred to the Company's portfolio. The Company evaluates certain loans for impairment when it is probable the payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Once a loan has been determined to be impaired, it is measured to establish the amount of the impairment, if any, based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, less cost to sell. If the measure of the impaired loan is less than the recorded investment in the loan, a valuation allowance is established. At December 31, 2011, a portion of the Company's total impaired loans were evaluated based on the fair value of the collateral. In accordance with fair value measurements, only impaired loans for which an allowance for loan loss has been established based on the fair value of collateral require classification in the fair value hierarchy. As a result, a portion, but not all, of the Company's impaired loans are classified in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or an estimate of fair value from an independent third-party real estate professional, the Company classifies the impaired loan as nonrecurring Level 2 in the fair value hierarchy. When an independent valuation is not available or there is no observable market price and fair value is based upon management's assessment of the liquidation value of collateral, the Company classifies the impaired loan as nonrecurring Level 3 in the fair value hierarchy.

Assets held in employee deferred compensation plans:

Assets held in employee deferred compensation plans are recorded at fair value and included in other assets on the Company's Consolidated Balance Sheets. The assets associated with these plans are primarily invested in mutual funds and classified as Level 1 as the fair value measurement is based upon available quoted prices. The Company also records a liability included in accrued interest, taxes and other liabilities on its Consolidated Balance Sheets for the amount due to employees related to these plans.

Derivatives:

The Company has determined that its derivative instrument valuations, except for the mortgage derivatives which are discussed separately, are classified in Level 2 of the fair value hierarchy. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves, and implied volatilities. In accordance with accounting guidance of fair value measurements, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty's nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings thresholds, mutual puts and guarantees.

Mortgage derivatives:

Mortgage derivatives include interest rate swaps hedging mortgage servicing rights, interest rate lock commitments to originate held for sale residential mortgage loans for individual customers and forward commitments to sell residential mortgage loans to various investors. The fair value of the interest rate swaps used to hedge mortgage servicing rights is classified in Level 2 of the hierarchy. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis of the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves, and implied volatilities. In accordance with accounting guidance of fair value measurements, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty's nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings thresholds, mutual puts and guarantees. The fair value of forward loan sale commitments is based upon quoted prices for similar assets in active market that the Company has the ability to access and is classified in Level 2 of the hierarchy. The Company uses an internal valuation model to estimate the fair value of its interest rate lock commitments which is based upon unobservable inputs that reflects management's assumptions and specific information about each borrower transaction and is classified in Level 3 of the hierarchy.

Mortgage servicing rights:

The Company records its mortgage servicing rights at fair value in other assets in the Consolidated Balance Sheets. Mortgage servicing rights do not trade in an active market with readily observable prices. Accordingly, the Company determines the fair value of mortgage servicing rights by estimating the fair value of the future cash flows associated with the mortgage loans being serviced. Key economic assumptions used in measuring the fair value of mortgage servicing rights include, but are not limited to, prepayment speeds, discount rates, delinquencies and cost to service. The assumptions used in the model are validated on a regular basis. The fair value is validated on a quarterly basis with a third party. Discrepancies between the internal model and the third party validation are investigated and resolved by an internal committee. Due to the nature of the valuation inputs, mortgage servicing rights are classified in Level 3 of the fair value hierarchy.

Other real estate owned and repossessed assets:

The Company does not record other real estate owned ("OREO") and repossessed assets at their fair value on a recurring basis. At foreclosure or obtaining possession of the assets, OREO and repossessed assets are recorded at the lower of the amount of the loan balance or the fair value of the collateral, less estimated costs to sell. Generally, the fair value of real estate is determined through the use of a current appraisal and the fair value of other repossessed assets is based upon the estimated net proceeds from the sale or disposition of the underlying collateral. Only assets that are recorded at fair value, less estimated cost to sell, are classified under the fair value hierarchy. When the fair value of the collateral is based upon an observable market price or an estimate of fair value from an independent third-party real estate professional, the Company classifies the OREO and repossessed asset as nonrecurring Level 2 in the fair value hierarchy. When an independent valuation is not available or there is no observable market price and fair value is based upon management's assessment of liquidation of collateral, the Company classifies the other real estate owned and repossessed assets as nonrecurring Level 3 in the fair value hierarchy.

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below:


	As of December 31, 2011
	Total Fair Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Assets:
Available for sale investment securities	$	1,175,380	$	—	$	1,174,561	$	819
Loans		5,124		—		5,124		—
Loans held for sale, at fair value		185,984		—		185,984		—
Assets held in employee deferred compensation plans		2,688		2,688		—		—
Derivative instruments		25,324		—		25,324		—
Mortgage derivative instruments		5,195		—		489		4,706
Mortgage servicing rights		8,742		—		—		8,742

Liabilities:
Derivative instruments		19,505		—		19,505		—
Mortgage derivative instruments		5,296		—		5,296		—

		00000000		00000000		00000000		00000000
	As of December 31, 2010
	Total Fair Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Assets:
Available for sale investment securities*	$	1,153,487	$	—	$	1,152,107	$	1,380
Loans held for sale, at fair value		259,020		—		259,020		—
Assets held in employee deferred compensation plans		2,575		2,575		—		—
Derivative instruments		14,245		—		14,245		—
Mortgage derivative instruments		4,049		—		3,611		438

Liabilities:
Derivative instruments		11,630		—		11,630		—

*	The fair value for certain available for sale investment securities for which the Company's independent pricing service does not have a fair value measurement was previously included in Level 2 of the fair value hierarchy. This disclosure has been modified to reflect these securities in Level 3.

The table below includes a rollforward of the Consolidated Balance Sheets amounts for the year ended December 31, 2011 and 2010 (including the change in fair value) for investment securities on a recurring basis and classified by the Company within Level 3 of the valuation hierarchy:


	For the Year Ended December 31,
	2011			2010
	(in thousands)
Beginning balance	$	1,380		$	2,050
Purchases		—			—
Maturities		(180	)		(600	)
Changes in assumptions		(381	)		(70	)

Fair value at period end	$	819		$	1,380

The table below includes a rollforward of the Consolidated Balance Sheets amounts for the year ended December 31, 2011 and 2010 (including the change in fair value) for mortgage derivative instruments measured on a recurring basis and classified by the Company within Level 3 of the valuation hierarchy:


	For the Year Ended December 31,
	2011		2010
	(in thousands)
Beginning balance	$	438	$	—
Mortgage derivative instruments gain, net		4,268		438

Fair value at period end	$	4,706	$	438

The table below includes a rollforward of the Consolidated Balance Sheets amounts for the year ended December 31, 2011 (including the change in fair value) for mortgage servicing rights measured on a recurring basis and classified by the Company within Level 3 of the valuation hierarchy:


	For the Year Ended December 31 2011
	(in thousands)
Beginning balance	$	—
MSR purchases		2,663
MSR originations		5,943
Change in assumptions		499
Other changes		(363	)

Fair value at period end	$	8,742

Assets Measured on a Nonrecurring Basis

Assets measured at fair value on a nonrecurring basis are summarized below. The Company may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis. These assets generally consist of loans considered impaired that may require periodic adjustment to the lower of cost or fair value.


	As of December 31, 2011
	Total Fair Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Assets:
Held to maturity securities	$	111,054	$	—	$	111,054	$	—
Loans		47,415		—		31,400		16,015
OREO and repossessed assets		28,782		—		—		28,782


	As of December 31, 2010
	Total Fair Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(in thousands)
Assets:
Held to maturity securities	$	101,751	$	—	$	101,751	$	—
Loans		76,546		—		51,100		25,446
OREO and repossessed assets		25,590		—		4,521		21,069

At December 31, 2011, the Company had $16.0 million of impaired loans and $28.8 million of OREO and repossessed assets measured at fair value on a nonrecurring basis and classified in Level 3 in the fair value hierarchy. The change in Level 3 carrying value of impaired loans during the year ended December 31, 2011 represents payments or net chargeoffs of $23.8 million, four additional impaired loans with fair value of $14.4 million and the related charge to earnings of $1.9 million to reduce these loans to fair value. The change in Level 3 OREO and repossessed assets during the year ended December 31, 2011 included $13.1 million of new additions, $4.1 million of transfers from Level 2 and $9.6 million of sales/settlements and writedowns.

At December 31, 2010, the Company had $25.4 million of impaired loans and $21.1 million of OREO and repossessed assets measured at fair value on a nonrecurring basis and classified in Level 3 in the fair value hierarchy. The change in Level 3 carrying value of impaired loans represents sales, payments or net chargeoffs of $11.4 million, nine additional impaired loans with fair value of $21.2 million and the related charge to earnings of $32.0 million to reduce these loans to fair value. The change in Level 3 OREO and repossessed assets during the year ended December 31, 2010 included $25.2 million of additions, $14.5 million of sales/settlements and writedowns.

Fair Value of Financial Instruments

The Company is required to provide certain disclosures of the estimated fair value of its financial instruments. A portion of the Company's assets and liabilities are considered financial instruments. Many of the Company's financial instruments, however, lack an available, or readily determinable, trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. The Company can use significant estimations and present value calculations for the purposes of estimating fair values. Accordingly, fair values are based on various factors relative to current economic conditions, risk characteristics, and other factors. The assumptions and estimates used in the fair value determination process are subjective in nature and involve uncertainties and significant judgment and, therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect these estimated values.

The methods and assumptions used to determine fair values for each significant class of financial instruments are presented below:

Cash and Cash Equivalents:

The carrying amount of cash, due from banks, interest-bearing deposits with banks or other financial institutions, federal funds sold, and securities purchased under agreement to resell with original maturities less than 90 days approximate fair value since their maturities are short-term.

Investment Securities:

The fair value measurements of investment securities consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, including credit spreads and current ratings from credit rating agencies and the bond's terms and conditions, among other things.

Loans Held For Sale:

For residential mortgage loans held for sale, the fair value has been determined based on quoted market prices for similar assets in active markets. For commercial loans held for sale, the fair value has been determined based upon the estimated net contracted sales prices, less cost to sell.

Loans:

The fair values of loans have been estimated by the present value of future cash flows, using current rates at which similar loans would be made to borrowers with the same remaining maturities, less a valuation adjustment for general portfolio risks. This method of estimating fair value does not incorporate the exit price concept of fair value prescribed by ASC "Fair Value Measurements and Disclosures, (Topic 820)." Certain loans are accounted for at fair value when it is probable the payment of interest and principal will not be made in accordance with the contractual terms and impairment exists. In these cases, the fair value is determined based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that collateral-dependent loans may be measured for impairment based on the fair value of the collateral, less cost to sell.

Investment in FHLB and FRB Stock:

The fair value of investments in FHLB and Federal Reserve Bank stock equals its book value as these stocks can only be sold back to the FHLB, Federal Reserve Bank, or other member banks at their par value per share.

Accrued Interest Receivable:

The carrying amount of accrued interest receivable approximates fair value since its maturity is short-term.

Derivative Financial Instruments:

The carrying amount and fair value of derivative financial instruments, such as interest rate swaps, floors, collars, and corridors are based on independent valuation models, which use widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty's nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral posting thresholds, mutual puts and guarantees.

The Company also has derivative financial instruments associated with Cole Taylor Mortgage including forward loan sale and interest rate lock commitments. The fair value of the forward loan sale commitments is based on quoted market prices for similar assets in active markets. The fair value of interest rate lock commitments is determined based on an internal valuation model using management assumptions and rate and pricing information from each loan commitment transaction. On the Company's Consolidated Balance Sheets, instruments that have a positive fair value are included in other assets and those instruments that have a negative fair value are included in accrued interest, taxes and other liabilities.

Other Assets:

Financial instruments in other assets consist of assets in the Company's nonqualified deferred compensation plan. The carrying value of these assets approximates their fair value and is based upon quoted market prices.

Deposit Liabilities:

Deposit liabilities with stated maturities have been valued at the present value of future cash flows using rates which approximate current market rates for similar instruments unless this calculation results in a present value which is less than the book value of the reflected deposit, in which case the book value would be utilized as an estimate of fair value. Fair values of deposits without stated maturities equal the respective amounts due on demand.

Other Borrowings:

The carrying amount of overnight securities sold under agreements to repurchase, federal funds purchased, and the U.S. Treasury tax and loan note option, approximates fair value, as the maturities of these borrowings are short-term. Securities sold under agreements to repurchase with original maturities over one year have been valued at the present values of future cash flows using rates which approximate current market rates for instruments of like maturities.

Notes Payable and Other Advances:

Notes payable and other advances have been valued at the present value of estimated future cash flows using rates which approximate current market rates for instruments of like maturities.

Accrued Interest Payable:

The carrying amount of accrued interest payable approximates fair value since its maturity is short-term.

Junior Subordinated Debentures:

The fair value of the fixed rate junior subordinated debentures issued to TAYC Capital Trust I is computed based upon the publicly quoted market prices of the underlying trust preferred securities issued by the Trust. The fair value of the floating rate junior subordinated debentures issued to TAYC Capital Trust II has been valued at the present value of estimated future cash flows using current market rates and credit spreads for an instrument with a like maturity.

Subordinated Notes:

The subordinated notes issued by the Bank in 2008 and by the Company in 2010, have been valued at the present value of estimated future cash flows using current market rates and credit spreads for an instrument with a like maturity.

Off-Balance Sheet Financial Instruments:

The fair value of commercial loan commitments to extend credit is not material as they are predominantly floating rate, subject to material adverse change clauses, cancelable and not readily marketable. The carrying value and the fair value of standby letters of credit represent the unamortized portion of the fee paid by the customer. A reserve for unfunded commitments is established if it is probable that a liability has been incurred by the Company under a standby letter of credit or a loan commitment that has not yet been funded.

The estimated fair values of the Company's financial instruments are as follows:


	December 31, 2011				December 31, 2010
	Carrying Value		Fair Value		Carrying Value		Fair Value
	(in thousands)
Financial Assets:
Cash and cash equivalents	$	121,164	$	121,164	$	81,329	$	81,329
Available for sale investments		1,175,380		1,175,380		1,153,487		1,153,487
Held to maturity investments		104,296		111,054		100,990		101,751
Loans held for sale		185,984		185,984		259,020		259,020
Loans, net of allowance		2,824,555		2,825,765		2,710,770		2,704,051
Investment in FHLB and FRB stock		56,781		56,781		40,032		40,032
Accrued interest receivable		15,472		15,472		15,707		15,707
Derivative financial instruments		30,519		30,519		18,294		18,294
Other assets		2,688		2,688		2,575		2,575

Total financial assets	$	4,516,839	$	4,524,807	$	4,382,204	$	4,376,246

Financial Liabilities:
Deposits without stated maturities	$	1,823,227	$	1,823,227	$	1,509,151	$	1,509,151
Deposits with stated maturities		1,299,984		1,312,956		1,517,755		1,540,863
Other borrowings		168,133		170,195		511,008		520,202
Notes payable and other advances		747,500		749,764		505,000		507,607
Accrued interest payable		5,741		5,741		8,318		8,318
Derivative financial instruments		24,801		24,801		11,630		11,630
Junior subordinated debentures		86,607		56,298		86,607		62,254
Subordinated notes, net		89,648		88,849		88,835		82,649

Total financial liabilities	$	4,245,641	$	4,231,831	$	4,238,304	$	4,242,674

Off-Balance-Sheet Financial Instruments:
Unfunded commitments to extend credit	$	4,368	$	4,368	$	5,417	$	5,417
Standby letters of credit		277		277		348		348

Total off-balance-sheet financial instruments	$	4,645	$	4,645	$	5,765	$	5,765

The remaining balance sheet assets and liabilities of the Company are not considered financial instruments and have not been valued differently than is required under historical cost accounting. Since assets and liabilities that are not financial instruments are excluded above, the difference between total financial assets and financial liabilities does not, nor is it intended to, represent the market value of the Company. Furthermore, the estimated fair value information may not be comparable between financial institutions due to the wide range of valuation techniques permitted, and assumptions necessitated, in the absence of an available trading market.