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 and retained mortgage servicing rights (“MSR”) asset at fair value, under the provisions of the 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. At March 31, 2015, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.19 billion, and the unpaid principal balance of those loans was $1.14 billion. At December 31, 2014, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.27 billion, and the unpaid principal balance of those loans was $1.22 billion. The interest component of fair value is reported as interest income on loans in the accompanying consolidated statements of operations.

On October 2, 2014, Hilltop exercised its warrant to purchase 8,695,652 shares of SWS common stock at an exercise price of $5.75 per share (the “SWS Warrant”) and paid the aggregate exercise price by the automatic elimination of the $50.0 million aggregate principal amount note due to Hilltop under its credit agreement with SWS. Following the exercise of the SWS Warrant, Hilltop owned approximately 21% of the outstanding shares of SWS common stock as of October 2, 2014. Contemporaneous with the exercise of the SWS Warrant, Hilltop changed the accounting method for its investment in SWS common stock and elected to account for its investment in accordance with the provisions of the Fair Value Option as permitted by GAAP. Hilltop had previously accounted for its investment in SWS common stock as an available for sale security. Under the Fair Value Option, Hilltop’s investment in SWS common stock is recorded at fair value effective October 2, 2014, with changes in fair value being recorded in other noninterest income within the consolidated statement of operations rather than as a component of other comprehensive income. At December 31, 2014, the fair value of Hilltop’s investment in SWS common stock was $70.3 million and is included in other assets within the consolidated balance sheet.

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 and data from independent pricing services.

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
March 31, 2015	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	40	$	314,181	$	5,932	$	320,153
Available for sale securities	14,070		845,142		—		859,212
Loans held for sale	—		1,168,757		19,495		1,188,252
Derivative assets	—		49,649		—		49,649
MSR asset	—		—		31,648		31,648
Trading liabilities	—		139,481		—		139,481
Derivative liabilities	—		22,048		—		22,048

	Level 1		Level 2		Level 3		Total
December 31, 2014	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	39	$	65,678	$	—	$	65,717
Available for sale securities	13,762		911,773		—		925,535
Loans held for sale	—		1,263,135		9,017		1,272,152
Derivative assets	—		23,805		—		23,805
MSR asset	—		—		36,155		36,155
Investment in SWS common stock	70,282		—		—		70,282
Trading liabilities	—		48		—		48
Derivative liabilities	—		12,849		—		12,849

The following tables include a rollforward 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			Purchases/		Sales/			Included in			Comprehensive		Balance at
	Period			Additions		Reductions			Net Income			Income (Loss)		End of Period
Three months ended March 31, 2015
Trading securities	$	—		$	7,301	$	—		$	(1,369	)	$	—	$	5,932
Loans held for sale	9,017			11,136		(271		)	(387		)	—		19,495
Mortgage servicing rights asset	36,155			2,690		—			(7,197		)	—		31,648
Total	$	45,172		$	21,127	$	(271	)	$	(8,953	)	$	—	$	57,075

Three months ended March 31, 2014
Available for sale securities	$	60,053		$	—	$	—		$	593		$	3,452	$	64,098
Loans held for sale	27,729			4,900		(5,594		)	(209		)	—		26,826
Mortgage servicing rights asset	20,149			7,432		—			2,358			—		29,939
Derivative liabilities	(5,600		)	—		—			(350		)	—		(5,950		)
Total	$	102,331		$	12,332	$	(5,594	)	$	2,392		$	3,452	$	114,913

All net realized and unrealized gains (losses) in the table above are reflected in the accompanying consolidated financial statements. The available for sale securities noted in the table above reflect Hilltop’s note receivable from SWS and the SWS Warrant. On October 2, 2014, as previously discussed, Hilltop exercised the SWS Warrant in full and paid the aggregate exercise price by the automatic elimination of the $50.0 million aggregate principal amount note due to Hilltop under the credit agreement.

For Level 3 financial instruments measured at fair value on a recurring basis at March 31, 2015, the significant unobservable inputs used in the fair value measurements were as follows.

			Range (Weighted-
Financial instrument	Valuation Technique	Unobservable Input	Average)
Trading securities	Discounted cash flow	Discount rate	8 - 17% (10%)

Loans held for sale	Discounted cash flow / Market comparable	Projected price	90 - 94% (93%)

Mortgage servicing rights asset	Discounted cash flow	Constant prepayment rate	14.95%
		Discount rate	10.98%

The fair value of certain loans held for sale that are either non-standard (i.e. loans that cannot be sold through normal sale channels) or non-performing is measured using unobservable inputs. The fair value of such loans is generally based upon estimates of expected cash flows using unobservable inputs including listing prices of comparable assets, uncorroborated expert opinions, and/or management’s knowledge of underlying collateral.

Trading securities include corporate debt securities that are valued using a discounted cash flow model with observable market data; however, due to the distressed nature of these bonds, the Company has determined that these securities should be valued as a Level 3 financial instrument.

The MSR asset, which is included in other assets within the Company’s consolidated balance sheets, is valued by projecting net servicing cash flows, which are then discounted to estimate the fair value. The fair value of the MSR asset is impacted by a variety of factors. Prepayment rates and discount rates, the most significant unobservable inputs, are discussed further in Note 7 to the consolidated financial statements.

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

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

	Three Months Ended March 31, 2015								Three Months Ended March 31, 2014
				Other		Total					Other		Total
	Net			Noninterest		Changes in			Net		Noninterest		Changes in
	Losses			Income		Fair Value			Gains		Income		Fair Value
Loans held for sale	$	(6,695	)	$	—	$	(6,695	)	$	4,518	$	—	$	4,518
Mortgage servicing rights asset	(7,197		)	—		(7,197		)	2,358		—		2,358

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 SWS Merger was determined at the acquisition 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. PCI loans with a fair value of $172.9 million, $822.8 million and $73.5 million were acquired by the Company upon completion of the merger with PlainsCapital (the “PlainsCapital Merger”), the FDIC-assisted transaction (the “FNB Transaction”) whereby the Bank acquired certain assets and assumed certain liabilities of First National Bank (“FNB”) and the SWS Merger, respectively (collectively, the “Bank Transactions”). 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 significant unobservable inputs regarding default rates, loss severity rates assuming default, prepayment speeds on acquired loans accounted for in pools (“Pooled Loans”), and estimated collateral values.

At March 31, 2015, estimates for these significant unobservable inputs were as follows.

	PCI Loans
	PlainsCapital		FNB		SWS
	Merger		Transaction		Merger
Weighted average default rate	47	%	60	%	52	%
Weighted average loss severity rate	50	%	39	%	37	%
Weighted average prepayment speed	0	%	4	%	0	%

The resulting weighted average expected loss on PCI loans associated with the PlainsCapital Merger, FNB Transaction and SWS Merger was 24%, 23% and 19%, respectively.

The Company obtains updated appraisals of the fair value of collateral securing impaired collateral dependent loans at least annually, in accordance with regulatory guidelines. The Company also reviews the fair value of such collateral on a quarterly basis. If the quarterly review indicates that the fair value of the collateral may have deteriorated, the Company will order an updated appraisal of the fair value of the collateral. Since the Company obtains updated appraisals when evidence of a decline in the fair value of collateral exists, it typically does not adjust appraised values.

Other Real Estate Owned — The Company reports other real estate owned (“OREO”) at fair value less estimated cost to sell. Any excess of recorded investment over fair value, less cost to sell, is charged against either the allowance for loan losses or the related PCI pool discount when property is initially transferred to OREO. Subsequent to the initial transfer to OREO, downward valuation adjustments are charged against earnings. The Company determines fair value primarily using independent appraisals of OREO properties. The resulting fair value measurements are classified as Level 2 or Level 3 inputs, depending upon the extent to which unobservable inputs determine the fair value measurement. The Company considers a number of factors in determining the extent to which specific fair value measurements utilize unobservable inputs, including, but not limited to, the inherent subjectivity in appraisals, the length of time elapsed since the receipt of independent market price or appraised value, and current market conditions. At March 31, 2015, the most significant unobservable input used in the determination of fair value of OREO was a discount to independent appraisals for estimated holding periods of OREO properties. Such discount was 1% per month for estimated holding periods of 6 to 24 months. Level 3 inputs were used to determine the initial fair value at acquisition of a large group of smaller balance properties that were acquired in the FNB Transaction. In the FNB Transaction, the Bank acquired OREO of $135.2 million, all of which is covered by FDIC loss-share agreements. At March 31, 2015 and December 31, 2014, the estimated fair value of covered OREO was $137.7 million and $136.9 million, respectively, and the underlying fair value measurements utilize Level 2 and Level 3 inputs. The fair value of non-covered OREO at March 31, 2015 and December 31, 2014 was $6.3 million and $0.8 million, respectively, and is included in other assets within the consolidated balance sheets. Level 3 inputs were used to determine the initial fair value at acquisition of properties totaling $5.6 million that were acquired in the SWS Merger. During the reported periods, all fair value measurements for non-covered OREO subsequent to initial recognition utilized Level 2 inputs.

The following table presents information regarding certain assets and liabilities measured at fair value on a non-recurring basis for which a change in fair value has been recorded during reporting periods subsequent to initial recognition (in thousands).

									Total Gains (Losses) for the
	Level 1		Level 2		Level 3		Total		Three Months Ended March 31,
March 31, 2015	Inputs		Inputs		Inputs		Fair Value		2015			2014
Non-covered impaired loans	$	—	$	—	$	23,605	$	23,605	$	349		$	(215	)
Covered impaired loans	—		—		68,195		68,195		3,218			(1,691		)
Non-covered other real estate owned	—		382		—		382		(28		)	(102		)
Covered other real estate owned	—		3,443		—		3,443		(950		)	(431		)

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 the Company’s 2014 Form 10-K.

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
March 31, 2015	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	708,533	$	708,533	$	—	$	—	$	708,533
Held to maturity securities	183,792		—		186,032		—		186,032
Loans held for sale	27,056		—		27,056		—		27,056
Non-covered loans, net	4,795,322		—		608,554		4,605,859		5,214,413
Covered loans, net	550,626		—		—		704,848		704,848
Broker-dealer and clearing organization receivables	2,222,517		—		2,222,517		—		2,222,517
FDIC indemnification asset	107,567		—		—		107,567		107,567
Other assets	61,362		—		45,784		15,578		61,362

Financial liabilities:
Deposits	7,129,277		—		7,138,613		—		7,138,613
Broker-dealer and clearing organization payables	1,951,040		—		1,951,040		—		1,951,040
Short-term borrowings	999,476		—		999,476		—		999,476
Debt	175,694		—		169,024		—		169,024
Other liabilities	2,095		—		2,095		—		2,095

			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
December 31, 2014	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	813,075	$	813,075	$	—	$	—	$	813,075
Held to maturity securities	118,209		—		118,345		—		118,345
Loans held for sale	37,541		—		37,541		—		37,541
Non-covered loans, net	3,883,435		—		378,425		3,528,769		3,907,194
Covered loans, net	638,029		—		—		767,751		767,751
Broker-dealer and clearing organization receivables	167,884		—		167,884		—		167,884
FDIC indemnification asset	130,437		—		—		130,437		130,437
Other assets	59,432		—		43,937		15,495		59,432

Financial liabilities:
Deposits	6,369,892		—		6,365,555		—		6,365,555
Broker-dealer and clearing organization payables	179,042		—		179,042		—		179,042
Short-term borrowings	762,696		—		762,696		—		762,696
Debt	123,696		—		117,028		—		117,028
Other liabilities	2,144		—		2,144		—		2,144