3. Fair Value Measurements

Fair Value Measurements and Disclosures

The Company determines fair values in compliance with The Fair Value Measurements and Disclosures Topic of the ASC (the “Fair Value Topic”). The Fair Value Topic defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The Fair Value Topic defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The Fair Value Topic assumes that transactions upon which fair value measurements are based occur in the principal market for the asset or liability being measured. Further, fair value measurements made under the Fair Value Topic exclude transaction costs and are not the result of forced transactions.

The Fair Value Topic creates a fair value hierarchy that classifies fair value measurements based upon the inputs used in valuing the assets or liabilities that are the subject of fair value measurements. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs, as indicated below.

· Level 1 Inputs: Unadjusted quoted prices in active markets for identical assets or liabilities that the Company can access at the measurement date.

· Level 2 Inputs: Observable inputs other than Level 1 prices. Level 2 inputs include 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, inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, prepayment speeds, default rates, credit risks, loss severities, etc.), and inputs that are derived from or corroborated by market data, among others.

· Level 3 Inputs: Unobservable inputs that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. Level 3 inputs include pricing models and discounted cash flow techniques, among others.

Fair Value Option

The Company has elected to measure substantially all of PrimeLending’s mortgage loans held for sale at fair value under the provisions of the Fair Value Option Subsections of the ASC (“Fair Value Option”). The Company elected to apply the provisions of the Fair Value Option to these items so that it would have 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 Company determines the fair value of the financial instruments accounted for under the provisions of the Fair Value Option in compliance with the provisions of the Fair Value Topic of the ASC discussed above.

At September 30, 2013, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.05 billion, and the unpaid principal balance of those loans was $1.00 billion. At December 31, 2012, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.40 billion, and the unpaid principal balance of those loans was $1.36 billion. The interest component of fair value is reported as interest income on loans in the accompanying consolidated statements of operations.

The Company holds a number of financial instruments that are measured at fair value on a recurring basis, either by the application of the Fair Value Option or other authoritative pronouncements. The fair values of those instruments are determined primarily using Level 2 inputs. Those inputs include quotes from mortgage loan investors and derivatives dealers, data from independent pricing services and rates paid in the brokered certificate of deposit market.

The following tables present information regarding financial assets and liabilities measured at fair value on a recurring basis (in thousands).

	Level 1		Level 2		Level 3		Total
September 30, 2013	Inputs		Inputs		Inputs		Fair Value
Cash and cash equivalents	$	1,016,274	$	—	$	—	$	1,016,274
Trading securities	—		43,254		—		43,254
Available for sale securities	20,996		1,198,783		59,602		1,279,381
Loans held for sale	—		1,046,152		—		1,046,152
Derivative assets	—		32,967		—		32,967
Mortgage servicing asset	—		—		13,401		13,401
Trading liabilities	—		46		—		46
Derivative liabilities	—		28,375		—		28,375

	Level 1		Level 2		Level 3		Total
December 31, 2012	Inputs		Inputs		Inputs		Fair Value
Cash and cash equivalents	$	726,460	$	—	$	—	$	726,460
Trading securities	—		90,113		—		90,113
Available for sale securities	20,428		914,248		56,277		990,953
Loans held for sale	—		1,400,737		—		1,400,737
Derivative assets	—		15,697		—		15,697
Mortgage servicing asset	—		—		2,080		2,080
Time deposits	—		1,073		—		1,073
Trading liabilities	—		3,164		—		3,164
Derivative liabilities	—		1,080		—		1,080

The following tables include a roll forward for those financial instruments measured at fair value using Level 3 inputs (in thousands).

							Total Gains or Losses
							(Realized or Unrealized)
	Balance at								Included in Other
	Beginning of						Included in		Comprehensive		Balance at
	Period		Purchases		Issuances		Net Income (Loss)		Income (Loss)		End of Period
Three months ended September 30, 2013
Available for sale securities	$	55,510	$	—	$	—	$	—	$	4,092	$	59,602
Mortgage servicing asset	7,111		—		4,079		2,211		—		13,401
Total	$	62,621	$	—	$	4,079	$	2,211	$	4,092	$	73,003

Nine months ended September 30, 2013
Available for sale securities	$	56,277	$	—	$	—	$	—	$	3,325	$	59,602
Mortgage servicing asset	2,080		—		8,384		2,937		—		13,401
Total	$	58,357	$	—	$	8,384	$	2,937	$	3,325	$	73,003

Three months ended September 30, 2012
Available for sale securities	$	54,577	$	—	$	—	$	—	$	7,491	$	62,068
Total	$	54,577	$	—	$	—	$	—	$	7,491	$	62,068

Nine months ended September 30, 2012
Available for sale securities	$	60,377	$	—	$	—	$	—	$	1,691	$	62,068
Total	$	60,377	$	—	$	—	$	—	$	1,691	$	62,068

All net unrealized gains (losses) in the table above are reflected in the accompanying consolidated financial statements. The unrealized gains (losses) relate to financial instruments still held at September 30, 2013. The available for sale securities noted in the tables above reflect Hilltop’s note receivable and warrant to purchase common stock of SWS Group, Inc. (“SWS”) as discussed in Note 4 to the consolidated financial statements.

Hilltop’s note receivable is valued using a cash flow model that estimates yield based on comparable securities in the market. The interest rate used to discount cash flows is the most significant unobservable input. An increase or decrease in the discount rate would result in a corresponding decrease or increase, respectively, in the fair value measurement of the note receivable.

The warrant is valued utilizing a binomial model. The underlying SWS common stock price and its related volatility, an unobservable input, are the most significant inputs into the model, and, therefore, decreases or increases to the SWS common stock price would result in a significant change in the fair value measurement of the warrant.

The mortgage servicing asset is valued by projecting net servicing cash flows, which are then discounted to estimate the fair value. The fair value of the mortgage servicing asset is impacted by a variety of factors, including prepayment assumptions, discount rates, delinquency rates, contractually specified servicing fees, servicing costs and underlying portfolio characteristics.

The Company had no transfers between Levels 1 and 2 during the periods presented.

The following tables present the changes in fair value for instruments that are reported at fair value under the Fair Value Option (in thousands).

	Changes in Fair Value for Assets and Liabilities Reported at Fair Value under Fair Value Option
	Three Months Ended September 30, 2013						Three Months Ended September 30, 2012
			Other		Total				Other		Total
	Net Gains from		Noninterest		Changes in		Net Gains from		Noninterest		Changes in
	Sale of Loans		Income		Fair Value		Sale of Loans		Income		Fair Value
Loans held for sale	$	44,395	$	—	$	44,395	$	—	$	—	$	—
Mortgage servicing asset	6,290		—		6,290		—		—		—
Time deposits	—		—		—		—		—		—

	Changes in Fair Value for Assets and Liabilities Reported at Fair Value under Fair Value Option
	Nine Months Ended September 30, 2013						Nine Months Ended September 30, 2012
			Other		Total				Other		Total
	Net Gains from		Noninterest		Changes in		Net Gains from		Noninterest		Changes in
	Sale of Loans		Income		Fair Value		Sale of Loans		Income		Fair Value
Loans held for sale	$	2,754	$	—	$	2,754	$	—	$	—	$	—
Mortgage servicing asset	11,321		—		11,321		—		—		—
Time deposits	—		12		12		—		—		—

The Company also determines the fair value of certain assets and liabilities on a non-recurring basis. In particular, the fair value of all of the assets acquired and liabilities assumed in the FNB Transaction was determined at the Bank Closing Date. In addition, facts and circumstances may dictate a fair value measurement when there is evidence of impairment. Assets and liabilities measured on a non-recurring basis include the items discussed below.

Impaired Loans — The Company reports impaired loans based on the underlying fair value of the collateral through specific allowances within the allowance for loan losses. The Company acquired PCI loans with a fair value of $172.9 million and $807.4 million upon completion of the PlainsCapital Merger and the FNB Transaction, respectively. Substantially all PCI loans acquired in the FNB Transaction are covered by FDIC loss-share agreements. The fair value of PCI loans was determined using Level 3 inputs, including estimates of expected cash flows that incorporated assumptions regarding default rates, loss severity rates assuming default, prepayment speeds and estimated collateral values. At September 30, 2013, non-covered PCI loans with a carrying amount of $139.2 million had been reduced by specific allowances within the allowance for non-covered loan losses of $3.0 million, resulting in a reported value of $136.2 million that approximates fair value. Covered PCI loans with a carrying amount of $782.6 million at September 30, 2013 approximated their fair value.

Other Real Estate Owned — The Company reports OREO at fair value less estimated cost to sell. Any excess of recorded investment over fair value less cost to sell is charged against the allowance for loan losses when property is initially transferred to OREO. Subsequent to the initial transfer to OREO, downward valuation adjustments are charged against earnings. The Company primarily determines fair value using Level 2 inputs consisting of independent appraisals. In the FNB Transaction, the Bank acquired OREO of $121.0 million, all of which is covered by an FDIC loss-share agreement. At September 30, 2013, the estimated fair value of covered OREO was $119.7 million. The fair value of non-covered OREO at September 30, 2013 was $7.0 million and is included in other assets within the consolidated balance sheet.

The Fair Value of Financial Instruments Subsection of the ASC requires disclosure of the fair value of financial assets and liabilities, including the financial assets and liabilities previously discussed. The methods for determining estimated fair value for financial assets and liabilities is described in detail in Note 3 to the consolidated financial statements included in our Annual Report on Form 10-K filed with the SEC on March 15, 2013, except as follows.

FDIC Indemnification Asset — The fair value of the FDIC Indemnification Asset is based on Level 3 inputs, including the discounted value of expected future cash flows under the loss-share agreements. The discount rate contemplates the credit worthiness of the FDIC as counterparty to this asset, and considers an incremental discount rate risk premium reflective of the inherent uncertainty associated with the timing of the cash flows.

The fair value of the assets acquired and liabilities assumed in the FNB Transaction was determined at Bank Closing Date. Given the short period of time that has elapsed between the Bank Closing Date and September 30, 2013, the fair value of the financial assets and liabilities shown at September 30, 2013 approximates their carrying values.

The following tables present the carrying values and estimated fair values of financial instruments not measured at fair value on either a recurring or non-recurring basis (in thousands).

			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
September 30, 2013	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Non-covered loans, net	$	3,277,044	$	—	$	286,663	$	3,018,250	$	3,304,913
Covered loans	1,096,590		—		—		1,096,590		1,096,590
Broker-dealer and clearing organization receivables	132,636		—		132,636		—		132,636
FDIC indemnification asset	190,041		—		—		190,041		190,041
Other assets	68,423		—		51,134		17,289		68,423

Financial liabilities:
Deposits	6,936,162		—		6,936,527		—		6,936,527
Broker-dealer and clearing organization payables	142,411		—		142,411		—		142,411
Short-term borrowings	305,297		—		305,297		—		305,297
Debt	207,123		—		231,416		—		231,416
Other liabilities	4,651		—		4,651		—		4,651

			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
December 31, 2012	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Non-covered loans, net	$	3,148,987	$	—	$	—	$	3,148,987	$	3,148,987
Broker-dealer and clearing organization receivables	145,564		—		145,564		—		145,564
Other assets	59,094		—		59,094		—		59,094

Financial liabilities:
Deposits	4,700,461		—		4,698,848		—		4,698,848
Broker-dealer and clearing organization payables	187,990		—		187,990		—		187,990
Short-term borrowings	728,250		—		728,250		—		728,250
Debt	208,551		—		217,092		—		217,092
Other liabilities	4,400		—		4,400		—		4,400