FAIR VALUE

9 Months Ended

Sep. 30, 2017

NOTE 22 – FAIR VALUE

Fair Value Measurement

The FASB authoritative guidance for fair value measurement defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance also establishes a fair value hierarchy for classifying financial instruments. The hierarchy is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Three levels of inputs may be used to measure fair value:


Level 1	Valuations of Level 1 assets and liabilities are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. Level 1 assets and liabilities include equity securities that trade in an active exchange market, as well as certain U.S. Treasury and other U.S. government and agency securities and corporate debt securities that are traded by dealers or brokers in active markets.

Level 2	Valuations of Level 2 assets and liabilities are based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include (i) mortgage-backed securities for which the fair value is estimated based on the value of identical or comparable assets, (ii) debt securities with quoted prices that are traded less frequently than exchange-traded instruments, and (iii) derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3	Valuations of Level 3 assets and liabilities are based on unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined by using pricing models for which the determination of fair value requires significant management judgments estimation.

For the first nine months of 2017, there were no transfers into or out of Level 1, Level 2 or Level 3 of the fair value hierarchy.

Financial Instruments Recorded at Fair Value on a Recurring Basis

Investment securities available for sale

The fair value of investment securities available for sale was the market value based on quoted market prices (as is the case with equity securities, Treasury notes, and non-callable U.S. Agency debt securities), when available (Level 1), or, when available, market prices for identical or comparable assets (as is the case with MBS and callable U.S. agency debt) that are based on observable market parameters, including benchmark yields, reported trades, quotes from brokers or dealers, issuer spreads, bids, offers and reference data including market research operations (Level 2). Observable prices in the market already consider the risk of nonperformance. If listed prices or quotes are not available, fair value is based upon discounted cash flow models that use unobservable inputs due to the limited market activity of the instrument, as is the case with certain private label mortgage-backed securities held by the Corporation (Level 3).

Private label MBS are collateralized by fixed-rate mortgages on single-family residential properties in the United States; the interest rate on the securities is variable, tied to 3-month LIBOR and limited to the weighted-average coupon of the underlying collateral. The market valuation represents the estimated net cash flows over the projected life of the pool of underlying assets applying a discount rate that reflects market observed floating spreads over LIBOR, with a widening spread based on a nonrated security. The market valuation is derived from a model that utilizes relevant assumptions such as the prepayment rate, default rate, and loss severity on a loan level basis. The Corporation modeled the cash flow from the fixed-rate mortgage collateral using a static cash flow analysis according to collateral attributes of the underlying mortgage pool (i.e., loan term, current balance, note rate, rate adjustment type, rate adjustment frequency, rate caps, and others) in combination with prepayment forecasts based on historical portfolio performance. The variable cash flow of the security is modeled using the 3-month LIBOR forward curve. Loss assumptions were driven by the combination of default and loss severity estimates, using an asset-level risk assessment method taking into account loan credit characteristics (loan-to-value, state jurisdiction, delinquency, property type and pricing behavior, and other) to provide an estimate of default and loss severity.

Refer to the table below for further information regarding qualitative information for all assets and liabilities measured at fair value using significant unobservable inputs (Level 3).

Derivative instruments

The fair value of most of the Corporation’s derivative instruments is based on observable market parameters and takes into consideration the credit risk component of paying counterparties, when appropriate. On interest rate caps, only the seller's credit risk is considered. The caps were valued using a discounted cash flow approach and using the related LIBOR and swap rate for each cash flow.

A credit spread is considered for those derivative instruments that are not secured. The cumulative mark-to-market effect of credit risk in the valuation of derivative instruments for the quarters and nine-month periods ended September 30, 2017 and 2016 was immaterial.

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

	As of September 30, 2017								As of December 31, 2016
	Fair Value Measurements Using								Fair Value Measurements Using
(In thousands)	Level 1		Level 2		Level 3		Assets/Liabilities at Fair Value		Level 1		Level 2		Level 3		Assets/Liabilities at Fair Value

Assets:
Securities available for sale :
Equity securities	$	418	$	-	$	-	$	418	$	408	$	-	$	-	$	408
U.S. Treasury Securities		7,432		-		-		7,432		7,509		-		-		7,509
Noncallable U.S. agency debt		-		364,859		-		364,859		-		356,919		-		356,919
Callable U.S. agency debt and MBS		-		1,353,262		-		1,353,262		-		1,469,463		-		1,469,463
Puerto Rico government obligations		-		4,162		2,609		6,771		-		24,707		2,121		26,828
Private label MBS		-		-		17,630		17,630		-		-		20,693		20,693
Other investments		-		-		100		100		-		-		100		100
Derivatives, included in assets:
Purchased interest rate cap agreements		-		219		-		219		-		554		-		554
Forward contracts		-		75		-		75		-		-		-		-
Liabilities:
Derivatives, included in liabilities:
Written interest rate cap agreements		-		219		-		219		-		552		-		552
Forward contracts		-		2		-		2		-		201		-		201

The table below presents a reconciliation of the beginning and ending balances of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarters and nine-month periods ended September 30, 2017 and 2016:

		Quarter Ended September 30,
		2017		2016
Level 3 Instruments Only		Securities		Securities
(In thousands)		Available For Sale⁽¹⁾		Available For Sale⁽¹⁾

Beginning balance		$	19,771	$	26,020
Total gains or (losses) (realized/unrealized):
Included in other comprehensive income			1,754		(477)
Principal repayments and amortization			(1,186)		(1,065)
Ending balance		$	20,339	$	24,478

(1)	Amounts mostly related to private label mortgage-backed securities.

		Nine-Month Period Ended September 30,
		2017		2016
Level 3 Instruments Only		Securities		Securities
(In thousands)		Available For Sale⁽¹⁾		Available For Sale⁽¹⁾

Beginning balance		$	22,914	$	27,297
Total gains or (losses) (realized/unrealized):
Included in earnings			-		(387)
Included in other comprehensive income			2,500		1,339
Principal repayments and amortization			(5,075)		(3,771)
Ending balance		$	20,339	$	24,478

(1)	Amounts mostly related to private label mortgage-backed securities.

The table below presents qualitative information for significant assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of September 30, 2017:

	September 30, 2017
(In thousands)	Fair Value		Valuation Technique	Unobservable Input	Range

Investment securities available-for-sale:

Private label MBS	$	17,630	Discounted cash flow	Discount rate	14.2%
				Prepayment rate	12.0% - 29.0% (Weighted Average 16.5%)
				Projected cumulative loss rate	0.1% - 7.1% (Weighted Average 4.0%)

Puerto Rico Government Obligations		2,609	Discounted cash flow	Discount rate	7.00%
				Prepayment rate	3.00%

Information about Sensitivity to Changes in Significant Unobservable Inputs

Private label MBS: The significant unobservable inputs in the valuation include probability of default, the loss severity assumption, and prepayment rates. Shifts in those inputs would result in different fair value measurements. Increases in the probability of default, loss severity assumptions, and prepayment rates in isolation would generally result in an adverse effect on the fair value of the instruments. Meaningful and possible shifts of each input were modeled to assess the effect on the fair value estimation.

Puerto Rico Government Obligations: The significant unobservable input used in the fair value measurement is the assumed prepayment rate of the underlying residential mortgage loans that collateralize these obligations that are guaranteed by the Puerto Rico Housing Finance Authority (“PRHFA”). A significant increase (decrease) in the assumed rate would lead to a higher (lower) fair value estimate. The fair value of these bonds was based on a discounted cash flow analysis that contemplates the credit quality of the holder of second mortgages and a discount for liquidity constraints on the bonds considering the absence of an active market for them. Due to the guarantee of the PRHFA and other applicable contractual safeguards, no additional credit spread is applied for servicer default.

The tables below summarize changes in unrealized gains and losses recorded in earnings for the quarters and nine-month periods ended September 30, 2017 and 2016 for Level 3 assets and liabilities that are still held at the end of each period:

	Changes in Unrealized Losses		Changes in Unrealized Losses
	(Quarter ended September 30, 2017)		(Quarter ended September 30, 2016)
Level 3 Instruments Only	Securities		Securities
(In thousands)	Available For Sale		Available For Sale

Changes in unrealized losses relating to assets still held at reporting date:
Net impairment losses on available-for-sale investment securities (credit component)	$	-	$	-

	Changes in Unrealized Losses		Changes in Unrealized Losses
	(Nine-Month Period Ended September 30, 2017)		(Nine-Month Period Ended September 30, 2016)
Level 3 Instruments Only	Securities		Securities
(In thousands)	Available For Sale		Available For Sale

Changes in unrealized losses relating to assets still held at reporting date:
Net impairment losses on available-for-sale investment securities (credit component)	$	-	$	(387)

Additionally, fair value is used on a nonrecurring basis to evaluate certain assets in accordance with GAAP. Adjustments to fair value usually result from the application of lower-of-cost or market accounting (e.g., loans held for sale carried at the lower-of-cost or fair value and repossessed assets) or write downs of individual assets (e.g., goodwill, loans).

As of September 30, 2017, impairment or valuation adjustments were recorded for assets recognized at fair value on a non-recurring basis as shown in the following table:

		Carrying value as of September 30, 2017						(Losses) recorded for the Quarter Ended September 30, 2017		(Losses) recorded for the Nine-Month Period Ended September 30, 2017
		Level 1		Level 2		Level 3
(In thousands)

Loans receivable⁽¹⁾		$	-	$	-	$	374,740	$	(686)	$	(23,467)
OREO⁽²⁾			-		-		152,977		(818)		(7,563)
Mortgage servicing rights⁽³⁾			-		-		25,999		(690)		(1,047)

(1)	Consist mainly of impaired commercial and construction loans. The impairments were generally measured based on the fair value of underlying the collateral. The fair values were derived from external appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the collateral (e.g., absorption rates), which are not market observable.
(2)	The fair values were derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the properties (e.g., absorption rates and net operating income of income producing properties), which are not market observable. Losses were related to market valuation adjustments after the transfer of the loans to the OREO portfolio.
(3)	Fair value adjustments to mortgage servicing rights were mainly due to assumptions associated with mortgage prepayment rates. The Corporation carries its mortgage servicing rights at the lower of cost or market, measured at fair value on a non-recurring basis. Assumptions for the value of mortgage servicing rights include: Prepayment rate of 6.41%, Discount Rate of 11.22%.

As of September 30, 2016, impairment or valuation adjustments were recorded for assets recognized at fair value on a non-recurring basis as shown in the following table:

		Carrying value as of September 30, 2016						(Losses) recorded for the Quarter Ended September 30, 2016		(Losses) recorded for the Nine-Month Period Ended September 30, 2016
		Level 1		Level 2		Level 3
(In thousands)

Loans receivable⁽¹⁾		$	-	$	-	$	426,444	$	(13,912)	$	(41,621)
OREO⁽²⁾			-		-		139,446		(1,702)		(6,580)
Mortgage servicing rights⁽³⁾			-		-		25,475		(263)		(387)

(1)	Consist mainly of impaired commercial and construction loans. The impairments were generally measured based on the fair value of the underlying collateral. The fair value was derived from external appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the collateral (e.g., absorption rates), which are not market observable.
(2)	The fair values were derived from appraisals that take into consideration prices in observed transactions involving similar assets in similar locations but adjusted for specific characteristics and assumptions of the properties (e.g., absorption rates and net operating income of income producing properties), which are not market observable. Losses were related to market valuation adjustments after the transfer of the loans to the OREO portfolio.
(3)	Fair value adjustments to the mortgage servicing rights were mainly due to assumptions associated with mortgage prepayments rates. The Corporation carries its mortgage servicing rights at the lower of cost or market, measured at fair value on a non-recurring basis. Assumptions for the value of mortgage servicing rights include: Prepayment Rate of 6.34%, Discount Rate of 11.18%.

Qualitative information regarding the fair value measurements for Level 3 financial instruments are as follows:

	September 30, 2017
	Method	Inputs
Loans	Income, Market, Comparable Sales, Discounted Cash Flows	External appraised values; probability weighting of broker price opinions; management assumptions regarding market trends or other relevant factors
OREO	Income, Market, Comparable Sales, Discounted Cash Flows	External appraised values; probability weighting of broker price opinions; management assumptions regarding market trends or other relevant factors
Mortgage servicing rights	Discounted Cash Flow	Weighted average prepayment rate of 6.41%; weighted average discount rate of 11.22%

The following is a description of the valuation methodologies used for instruments that are not measured or reported at fair value on a recurring basis or reported at fair value on a non-recurring basis. The estimated fair value was calculated using certain facts and assumptions, which vary depending on the specific financial instrument.

Cash and due from banks and money market investments

The carrying amounts of cash and due from banks and money market investments are reasonable estimates of their fair value. Money market investments include held-to-maturity securities, which have a contractual maturity of three months or less. The fair value of these securities is based on quoted market prices in active markets that incorporate the risk of nonperformance.

Investment securities held to maturity

Investment securities held to maturity consist of financing arrangements with Puerto Rico municipalities issued in bond form, but underwritten as loans with features that are typically found in commercial loan transactions. These obligations typically are not issued in bearer form, nor are they registered with the SEC and are not rated by external credit agencies. The fair value of these financing arrangements was based on a discounted cash flow analysis using risk-adjusted discount rates (Level 3). The credit spreads for valuations are based on a similar security that traded in the open market.

Other equity securities

Equity or other securities that do not have a readily available fair value are stated at their net realizable value, which management believes is a reasonable proxy for their fair value. This category is principally composed of stock that is owned by the Corporation to comply with FHLB regulatory requirements. The realizable value of the FHLB stock equals its cost as this stock can be freely redeemed at par.

Loans receivable, including loans held for sale

The fair values of loans held for investment and of mortgage loans held for sale were estimated using discounted cash flow analyses, based on interest rates currently being offered for loans with similar terms and credit quality and with adjustments that the Corporation’s management believes a market participant would consider in determining fair value. Loans were classified by type, such as commercial, residential mortgage, and automobile. These asset categories were further segmented into fixed- and adjustable-rate categories. Valuations are carried out based on categories and not on a loan-by-loan basis. The fair values of performing fixed-rate and adjustable-rate loans were calculated by discounting expected cash flows through the estimated maturity date. This fair value is not currently an indication of an exit price as that type of assumption could result in a different fair value estimate. The fair values of credit card loans were estimated using a discounted cash flow method and excludes any value related to a customer account relationship. Other loans with no stated maturity, like credit lines, were valued at book value. Prepayment assumptions were considered for non-residential loans. For residential mortgage loans, prepayment estimates were based on a prepayment model that combined both a historical calibration and current market prepayment expectations. Discount rates were based on the U.S. Treasury and LIBOR/Swap Yield Curves at the date of the analysis, and included appropriate adjustments for expected credit losses and liquidity. For impaired collateral dependent loans, the impairment was primarily measured based on the fair value of the collateral, which is derived from appraisals that take into consideration prices in observable transactions involving similar assets in similar locations.

Deposits

The estimated fair values of demand deposits and savings accounts, which are deposits with no defined maturities, equals the amount payable on demand at the reporting date. The fair values of retail fixed-rate time deposits, with stated maturities, are based on the present value of the future cash flows expected to be paid on the deposits. The cash flows were based on contractual maturities; no early repayments were assumed. Discount rates were based on the LIBOR yield curve.

The estimated fair value of total deposits excludes the fair value of core deposit intangibles, which represent the value of the customer relationship. The fair value of total deposits is measured by the value of demand deposits and savings deposits that bear a low or zero rate of interest and do not fluctuate in response to changes in interest rates.

The fair values of brokered CDs, which are included within deposits, are determined using discounted cash flow analyses over the full terms of the CDs. The fair values of the CDs are computed using the outstanding principal amount. The discount rates used were based on brokered CD market rates as of September 30, 2017. The fair values do not incorporate the risk of nonperformance, since interests in brokered CDs are generally sold by brokers in amounts of less than $250,000 and, therefore, are insured by the FDIC.

Securities sold under agreements to repurchase

Some repurchase agreements reprice at least quarterly, and their outstanding balances are estimated to be their fair value. Where longer commitments are involved, fair values are estimated using exit price indications of the cost of unwinding the transactions as of the end of the reporting period. The brokers who are the counterparties provide these indications, which the Corporation evaluates. Securities sold under agreements to repurchase are fully collateralized by investment securities.

Advances from the FHLB

The fair values of advances from the FHLB with fixed maturities are determined using discounted cash flow analyses over the full terms of the borrowings, using indications of the fair value of similar transactions. The cash flows assume no early repayment of the borrowings. Discount rates are based on the LIBOR yield curve. Advances from the FHLB are fully collateralized by mortgage loans and, to a lesser extent, investment securities.

Other borrowings

Other borrowings consist of junior subordinated debentures. Projected cash flows from the debentures were discounted using the Bloomberg BB Finance curve plus a credit spread. This credit spread was estimated using the difference in yield curves between swap rates and a yield curve that considers the industry and credit rating of the Corporation as issuer of the debentures at a tenor comparable to the time to maturity of the debentures.

The following tables present the carrying value, estimated fair value and estimated fair value level of hierarchy of financial instruments as of September 30, 2017 and December 31, 2016:

	Total Carrying Amount in Statement of Financial Condition September 30, 2017		Fair Value Estimate September 30, 2017		Level 1		Level 2		Level 3

(In thousands)

Assets:
Cash and due from banks and money
market investments	$	737,194	$	737,194	$	737,194	$	-	$	-
Investment securities available
for sale		1,750,472		1,750,472		7,850		1,722,283		20,339
Investment securities held to maturity		150,627		130,125		-		-		130,125
Other equity securities		52,119		52,119		-		52,119		-
Loans held for sale		27,576		29,612		-		19,826		9,786
Loans held for investment		8,877,214
Less: allowance for loan and lease losses		(230,870)
Loans held for investment, net of allowance	$	8,646,344		8,354,635		-		-		8,354,635
Derivatives, included in assets		294		294		-		294		-

Liabilities:
Deposits		8,765,891		8,769,746		-		8,769,746		-
Securities sold under agreements to repurchase		300,000		329,444		-		329,444		-
Advances from FHLB		915,000		913,134		-		913,134		-
Other borrowings		208,639		180,305		-		-		180,305
Derivatives, included in liabilities		221		221		-		221		-

	Total Carrying Amount in Statement of Financial Condition December 31, 2016		Fair Value Estimate December 31, 2016		Level 1		Level 2		Level 3

(In thousands)

Assets:
Cash and due from banks and money
market investments	$	299,685	$	299,685	$	299,685	$	-	$	-
Investment securities available
for sale		1,881,920		1,881,920		7,917		1,851,089		22,914
Investment securities held to maturity		156,190		132,759		-		-		132,759
Other equity securities		42,992		42,992		-		42,992		-
Loans held for sale		50,006		52,707		-		42,921		9,786
Loans held for investment		8,886,873
Less: allowance for loan and lease losses		(205,603)
Loans held for investment, net of allowance	$	8,681,270		8,455,104		-		-		8,455,104
Derivatives, included in assets		554		554		-		554		-

Liabilities:
Deposits		8,831,205		8,838,606		-		8,838,606		-
Securities sold under agreements to repurchase		300,000		335,840		-		335,840		-
Advances from FHLB		670,000		669,687		-		669,687		-
Other borrowings		216,187		171,374		-		-		171,374
Derivatives, included in liabilities		753		753		-		753		-

- 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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