NOTE 3 – FAIR VALUES OF FINANCIAL INSTRUMENTS

Fair Value Hierarchy. ASC 820-10 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The topic describes three levels of inputs that may be used to measure fair value:

•

Level 1: Quoted prices (unadjusted) 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; or other inputs that are observable or can be corroborated by observable market data.

•

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

Securities Available for Sale. The fair values of securities available for sale are generally determined by quoted market prices, if available (Level 1), or by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). The fair values of the Company’s Level 3 securities are determined by the Company or an independent third-party provider using a discounted cash flow methodology. The methodology uses discount rates that are based upon observed market yields for similar securities. Prepayment speeds are estimated based upon the prepayment history of each bond and a detailed analysis of the underlying collateral. Gross weighted average coupon, geographic concentrations, loan to value, FICO and seasoning are among the different loan attributes that are factored into our prepayment curve. Default rates and severity are estimated based upon geography of the collateral, delinquency, modifications, loan to value ratios, FICO scores, and past performance.

Impaired Loans and Leases. The fair value of impaired loans and leases with specific allocations of the allowance for loan and lease losses based on collateral values is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Loans Held for Sale. The fair value of loans held for sale is based on commitments outstanding from investors as well as what secondary markets are currently offering for portfolios with similar characteristics. Therefore, loans held for sale subjected to recurring fair value adjustments are classified as Level 2. The Company had $169.2 million and $192.6 million of loans held for sale at such fair values at March 31, 2014 and December 31, 2013, respectively. The Company also had $831.2 million and $524.1 million of non-conforming jumbo mortgage loans held for sale at the lower of cost or fair value at March 31, 2014 and December 31, 2013, respectively. The Company obtains quotes, bid or pricing indications on all or part of these loans directly from the buyers. Premiums and discounts received or to be received on the quotes, bids or pricing indications are indicative of the fact that the cost is lower or higher than fair value.

Derivative Assets and Liabilities. The Company’s derivative assets and liabilities are carried at fair value as required by GAAP and are accounted for as freestanding derivatives. The Company has entered into pay-fixed, receive-variable interest rate swap contracts with institutional counterparties to hedge against variability in cash flow attributable to interest rate risk caused by changes in the LIBOR benchmark interest rate on the Company’s ongoing LIBOR-based variable rate deposits. The Company is accounting for the swaps as cash flow hedges under ASC 815. The other derivative assets are interest rate lock commitments (IRLCs) with prospective residential mortgage borrowers whereby the interest rate on the loan is locked by borrower prior to funding. These IRLCs are determined to be derivative instruments in accordance with GAAP. Additional derivative assets and liabilities, typically mortgage-backed to-be-announced (TBA) securities, are used to hedge fair value changes, driven by changes in interest rates, on the Company’s mortgage assets. The Company hedges the period from the interest rate lock (assuming a fall-out factor) to the date of the loan sale. The estimated fair value is based on current market prices for similar instruments. Given the meaningful level of secondary market activity for derivative contracts, active pricing is available for similar assets and accordingly, the Company classifies its derivative assets and liabilities as Level 2.

Servicing Rights – Mortgage. The Company retains servicing on some of its mortgage loans sold and elected the fair value option for valuation of these mortgage servicing rights (MSRs). The value is based on a third party provider that calculates the present value of the expected net servicing income from the portfolio based on key factors that include interest rates, prepayment assumptions, discount rate and estimated cash flows. Because of the significance of unobservable inputs, these servicing rights are classified as Level 3.

Other Real Estate Owned Assets. Other real estate owned assets (OREO) are recorded at the fair value less estimated costs to sell at the time of foreclosure. The fair value of other real estate owned assets is generally based on recent real estate appraisals adjusted for estimated selling costs. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments may be significant and result in a Level 3 classification of the inputs for determining fair value. Only OREO with a valuation allowance are considered to be carried at fair value. For the three months ended March 31, 2014 and 2013, the Company experienced none and $79 thousand in valuation allowance expense for those assets, respectively.

Assets and Liabilities Measured on a Recurring and Non-Recurring Basis

Available-for-sale securities, certain conforming mortgage loans held for sale, derivative assets and liabilities, and servicing rights—mortgage are measured at fair value on a recurring basis, whereas impaired loans and leases, non-conforming jumbo mortgage loans held for sale and other real estate owned are measured at fair value on a non-recurring basis.

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


			Fair Value Measurements Level
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
	Value		(Level One)		(Level Two)		(Level Three)
	(In thousands)
March 31, 2014:
Assets
Available-for-sale securities:
SBA loan pools securities	$	1,702	$	—	$	1,702	$	—
U.S. government-sponsored entities and agency securities		1,958		—		1,958		—
Private label residential mortgage-backed securities		5,067		—		5,067		—
Agency mortgage-backed securities		98,798		—		98,798		—
Loans held for sale		169,197		—		169,197		—
Derivative assets ⁽¹⁾		4,469		—		4,469		—
Mortgage servicing rights ⁽²⁾		18,553		—		10,146		8,407
Liabilities
Derivative liabilities ⁽³⁾		64		—		64		—
December 31, 2013:
Assets
Available-for-sale securities:
SBA loan pools securities	$	1,736	$	—	$	1,736	$	—
U.S. government-sponsored entities and agency securities		1,920		—		1,920		—
Private label residential mortgage-backed securities		14,752		—		14,752		—
Agency mortgage-backed securities		151,614		—		151,614		—
Loans held for sale		192,613		—		192,613		—
Derivative assets ⁽¹⁾		5,493		—		5,493		—
Mortgage servicing rights ⁽²⁾		13,535		—		—		13,535
Liabilities
Derivative liabilities ⁽³⁾		—		—		—		—

⁽¹⁾

Included in other assets on the consolidated statements of financial condition

⁽²⁾

Included in servicing rights, net and servicing rights held for sale on the consolidated statements of financial condition

⁽³⁾

Included in accrued expenses and other liabilities on the consolidated statements of financial condition

During the three months ended March 31, 2014, the Company entered into an agreement with a third party to sell servicing rights on mortgage loans with $941.1 million of outstanding unpaid principal balance at March 31, 2014 for a fair value of $10.1 million. The sale closed on April 1, 2014. The fair values on the sold MSRs are carried at the closing price of the transaction at March 31, 2014, therefore, we transferred the amount to Level 2. The Company will continue to be the interim servicer until later in the second quarter.

The following table presents the Company’s financial assets and liabilities measured at fair value on a non-recurring basis as of the dates indicated:


			Fair Value Measurements Level
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
	Value		(Level One)		(Level Two)		(Level Three)
	(In thousands)
March 31, 2014:
Assets
Impaired loans:
Real estate 1-4 family first mortgage	$	10,160	$	—	$	3,094	$	7,066
Real estate mortgage		3,218		—		—		3,218
Multifamily		1,674		—		—		1,674
HELOC’s, home equity loans, and other consumer installment credit		212		—		212		—
Other real estate owned
Real estate 1-4 family first mortgage		150		—		150		—
December 31, 2013:
Assets
Impaired loans:
Real estate 1-4 family first mortgage	$	12,814	$	—	$	8,769	$	4,045
Real estate mortgage		3,868		—		105		3,763
Multifamily		1,972		—		—		1,972
HELOC’s, home equity loans, and other consumer installment credit		249		—		216		33
Commercial and industrial		33		—		—		33
SBA		10		—		—		10

The Company did not have any other real estate owned at December 31, 2013.

The following table presents the gains and (losses) recognized on assets measured at fair value on a non-recurring basis for the periods indicated:


	Three months ended
	March 31,
	2014			2013
	(In thousands)
Impaired loans:
Real estate 1-4 family first mortgage	$	(151	)	$	(124	)
Multifamily		—			(296	)
HELOC’s, home equity loans, and other consumer installment credit		(2	)		(2	)
Other real estate owned assets		—			35

The following table presents a reconciliation of assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods indicated:


	Private label
	residential			Mortgage
	mortgage-backed			Servicing
	securities			Rights			Total
	(In thousands)
Balance of recurring Level 3 assets at December 31, 2013	$	—		$	13,535		$	13,535
Transfers out of Level 3 ⁽¹⁾		—			(9,185	)		(9,185	)
Total gains or losses (realized/unrealized):
Included in earnings—realized		—			—			—
Included in earnings—fair value adjustment		—			315			315
Included in other comprehensive income		—			—			—
Amortization of premium (discount)		—			—			—
Additions		—			4,326			4,326
Sales and settlements		—			(584	)		(584	)

Balance of recurring Level 3 assets at March 31, 2014	$	—		$	8,407		$	8,407

Balance of recurring Level 3 assets at December 31, 2012	$	2,214		$	1,739		$	3,953
Transfers out of Level 3 ⁽¹⁾		—			—			—
Total gains or losses (realized/unrealized):
Included in earnings—realized		—			—			—
Included in earnings—fair value adjustment		—			25			25
Included in other comprehensive income		(1	)		—			(1	)
Amortization of premium (discount)		—			—			—
Additions		—			910			910
Sales and settlements		(294	)		(95	)		(389	)

Balance of recurring Level 3 assets at March 31, 2013	$	1,919		$	2,579		$	4,498

(1)

The Company’s policy is to recognize transfers in and transfers out as of the actual date of the event or change in circumstances that cause the transfer.

The following table presents quantitative information about Level 3 fair value measurements on a recurring basis as of the dates indicated:


	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
	($ in thousands)
March 31, 2014:
Mortgage servicing rights	$	8,407	Discounted cash flow	Discount rate	10.00% to 17.89% (10.81%)
				Prepayment rate	3.92% to 34.54% (13.17%)
December 31, 2013:
Mortgage servicing rights	$	13,535	Discounted cash flow	Discount rate	10.00% to 17.94% (10.26%)
				Prepayment rate	4.19% to 34.54% (9.85%)

The significant unobservable inputs used in the fair value measurement of the Company’s servicing rights include the discount rate and estimated cash flows. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results.

The significant unobservable inputs used in the fair value measurement of the Company’s private label and agency residential mortgage backed securities are prepayment rates, collateral default rates, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the collateral default rates is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.

The following table presents the carrying amounts and estimated fair values of financial assets and liabilities as of the dates indicated:


	Carrying		Fair Value Measurements Level
	Amount		Level 1		Level 2		Level 3		Total
	(In thousands)
March 31, 2014:
Financial assets
Cash and cash equivalents	$	333,639	$	333,639	$	—	$	—	$	333,639
Time deposits in financial institutions		1,745		1,745		—		—		1,745
Securities available-for-sale		107,525		—		107,525		—		107,525
FHLB and other bank stock		26,801		—		26,801		—		26,801
Loans held for sale		1,000,394		—		1,000,394		—		1,000,394
Loans and leases receivable, net of allowance		2,376,992		—		—		2,414,917		2,414,917
Accrued interest receivable		10,962		10,962		—		—		10,962
Derivative assets		4,469		—		4,469		—		4,469
Financial liabilities
Deposits		3,109,146		—		3,074,457		—		3,074,457
Advances from the FHLB		395,000		—		395,074		—		395,074
Federal funds purchased		70,000		70,000		—		—		70,000
Notes payable		82,416		86,615		—		—		86,615
Derivative liabilities		64		—		64		—		64
Accrued interest payable		1,628		1,628		—		—		1,628
December 31, 2013:
Financial assets
Cash and cash equivalents	$	110,118	$	110,118	$	—	$	—	$	110,118
Time deposits in financial institutions		1,846		1,846		—		—		1,846
Securities available-for-sale		170,022		—		170,022		—		170,022
FHLB and other bank stock		22,600		—		22,600		—		22,600
Loans held for sale		716,733		—		719,496		—		719,496
Loans and leases receivable, net of allowance		2,427,306		—		—		2,460,953		2,460,953
Accrued interest receivable		10,866		10,866		—		—		10,866
Derivative assets		5,493		—		5,493		—		5,493
Financial liabilities
Deposits		2,918,644		—		2,877,650		—		2,877,650
Advances from the FHLB		250,000		—		250,090		—		250,090
Notes payable		82,320		85,564		—		—		85,564
Derivative liabilities		—		—		—		—		—
Accrued interest payable		1,646		1,646		—		—		1,646

The methods and assumptions used to estimate fair value are described as follows:

Carrying amount is the estimated fair value for cash and cash equivalents, time deposits in financial institutions, and accrued interest receivable and payable. The methods for determining the fair values for securities available for sale, and derivatives assets and liabilities are described above. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair value of FHLB advances and long-term debt is based on current rates for similar financing, and therefore not indicative of an exit price. It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability. Carrying amount of federal funds purchased is the estimated fair value due to the short-term nature of this liability, as all outstanding federal funds purchased were over-night borrowings at March 31, 2014. The fair value of off-balance-sheet items is not considered material (or is based on the current fees or costs that would be charged to enter into or terminate such arrangements) and is not presented.