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 (such as interest rates, yield curves, prepayment speeds, default rates, credit risks and loss severities), 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 the 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 December 31, 2015 and 2014, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.46 billion and $1.27 billion, respectively, and the unpaid principal balance of those loans was $1.41 billion and $1.22 billion, respectively. 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 statements of operations rather than as a component of other comprehensive income. Hilltop’s election to apply the provisions of the Fair Value Option resulted in Hilltop recording those unrealized gains previously associated with its investment in SWS common stock of $7.2 million. For the period from October 3, 2014 through December 31, 2014, the change in fair value of Hilltop’s investment in SWS common stock resulted in a loss of $1.2 million. In the aggregate, Hilltop recorded a $6.0 million net gain in other noninterest income within the consolidated statement of operations during 2014. At December 31, 2014, the fair value of Hilltop’s investment in SWS common stock was $70.3 million and was 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, as further described below.

Trading Securities — Trading securities are reported at fair value primarily using either Level 1 or Level 2 inputs in the same manner as discussed below for available for sale securities. 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.

Available For Sale Securities — Most securities available for sale are reported at fair value using Level 2 inputs. The Company obtains fair value measurements from independent pricing services. As the Company is responsible for the determination of fair value, control processes are designed to ensure that the fair values received from independent pricing services are reasonable and the valuation techniques and assumptions used appear reasonable and consistent with prevailing market conditions. 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 and the financial instruments’ terms and conditions, among other things. For public common and preferred equity stocks, the determination of fair value uses Level 1 inputs based on observable market transactions.

Loans Held for Sale — Mortgage loans held for sale are reported at fair value, as discussed above, using Level 2 inputs that consist of commitments on hand from investors or prevailing market prices. These instruments are held for relatively short periods, typically no more than 30 days. As a result, changes in instrument-specific credit risk are not a significant component of the change in fair value. The fair value of certain loans held for sale that cannot be sold through normal sale channels or are non-performing is measured using Level 3, or 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.

Derivatives – Derivatives are reported at fair value using either Level 2 or Level 3 inputs. PrimeLending and the Hilltop Broker-Dealers use dealer quotes to value forward purchase commitments and forward sale commitments, respectively, executed for both hedging and non-hedging purposes. PrimeLending also issues IRLCs to its customers and the Hilltop Broker-Dealers issue forward purchase commitments to its clients that are valued based on the change in the fair value of the underlying mortgage loan from inception of the IRLC or purchase commitment to the balance sheet date, adjusted for projected loan closing rates. PrimeLending determines the value of the underlying mortgage loan as discussed in “Loans Held for Sale”, above. The Hilltop Broker-Dealers determine the value of the underlying mortgage loan from prices of comparable securities used to value forward sale commitments. Additionally, PrimeLending uses dealer quotes to value interest rate swaps and swaptions executed to hedge its MSR asset and First Southwest entered into a derivative option agreement (“Fee Award Option”) valued using discounted cash flow and probability of exercise. The Fee Award Option was exercised during the fourth quarter of 2014.

MSR Asset – The MSR asset is reported at fair value using Level 3 inputs. Fair value is determined 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 10 to the consolidated financial statements.

Securities Sold, Not Yet Purchased – Securities sold, not yet purchased are reported at fair value primarily using either Level 1 or Level 2 inputs in the same manner as discussed above for trading and available for sale securities.

Investment in SWS Common Stock – The investment in SWS common stock was reported at fair value at December 31, 2014 using quoted market prices for SWS’s common stock as traded on the NYSE, a Level 1 input. This investment in SWS Common Stock was reflected in the aggregate purchase price associated with the SWS Merger and reclassified as an investment in subsidiaries, which is eliminated in consolidation.

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
December 31, 2015	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	21,807	$	192,338	$	1	$	214,146
Available for sale securities		17,409		656,297		—		673,706
Loans held for sale		—		1,434,955		25,880		1,460,835
Derivative assets		—		35,676		—		35,676
MSR asset		—		—		52,285		52,285
Securities sold, not yet purchased		27,648		102,396		—		130,044
Derivative liabilities		—		5,426		—		5,426


	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
Securities sold, not yet purchased		—		48		—		48
Derivative liabilities		—		12,849		—		12,849

The following table includes 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/		Transfers into		Included in		Comprehensive		Balance at
	Year		Additions		Reductions		Level 3		Net Income		Income (Loss)		End of Year
Year ended December 31, 2015
Trading securities	$	—	$	7,301	$	(3,397)	$	—	$	(3,903)	$	—	$	1
Loans held for sale		9,017		52,800		(25,514)		—		(10,423)		—		25,880
MSR asset		36,155		24,974		—		—		(8,844)		—		52,285
Total	$	45,172	$	85,075	$	(28,911)	$	—	$	(23,170)	$	—	$	78,166

Year ended December 31, 2014
Available for sale securities	$	60,053	$	—	$	(61,283)	$	—	$	1,848	$	(618)	$	—
Loans held for sale		27,729		24,851		(44,597)		—		1,034		—		9,017
MSR asset		20,149		35,056		(11,387)		—		(7,663)		—		36,155
Derivative liabilities		(5,600)		(177)		6,827		—		(1,050)		—		—
Total	$	102,331	$	59,730	$	(110,440)	$	—	$	(5,831)	$	(618)	$	45,172

Year ended December 31, 2013
Available for sale securities	$	56,277	$	—	$	—	$	—	$	2,166	$	1,610	$	60,053
Loans held for sale		—		—		—		27,729		—		—		27,729
MSR asset		2,080		13,886		—		—		4,183		—		20,149
Derivative liabilities		(4,490)		—		—		—		(1,110)		—		(5,600)
Total	$	53,867	$	13,886	$	—	$	27,729	$	5,239	$	1,610	$	102,331

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, which, as previously discussed, Hilltop exercised in full on October 2, 2014. Excluding these available for sale securities and derivative liabilities representing the Fee Award Option entered into by First Southwest, the unrealized gains (losses) relate to financial instruments still held at December 31, 2015.

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


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

Loans held for sale	Discounted cash flow / Market comparable	Projected price	93	-	95	%	(	95	%)

MSR asset	Discounted cash flow	Constant prepayment rate			11.51		%
		Discount rate			10.92		%

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).


	Year Ended December 31, 2015						Year Ended December 31, 2014						Year Ended December 31, 2013
			Other		Total				Other		Total				Other		Total
	Net		Noninterest		Changes in		Net		Noninterest		Changes in		Net		Noninterest		Changes in
	Gains (Losses)		Income		Fair Value		Gains (Losses)		Income		Fair Value		Gains (Losses)		Income		Fair Value
Loans held for sale	$	(2,970)	$	—	$	(2,970)	$	31,805	$	—	$	31,805	$	(19,353)	$	—	$	(19,353)
Investment in SWS common stock		—		—		—		—		5,985		5,985		—		—		—
MSR asset		(8,844)		—		(8,844)		(7,663)		—		(7,663)		4,183		—		4,183
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 PlainsCapital Merger and SWS Merger were determined at the respective acquisition date, while fair value of all 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. 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 PlainsCapital Merger, the FNB Transaction 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 December 31, 2015, estimates for these significant unobservable inputs were as follows.


	PCI Loans
	PlainsCapital		FNB		SWS
	Merger		Transaction		Merger
Weighted average default rate	57	%	56	%	48	%
Weighted average loss severity rate	49	%	35	%	31	%
Weighted average prepayment speed	0	%	6	%	0	%

At December 31, 2015, the resulting weighted average expected loss on PCI loans associated with the PlainsCapital Merger, FNB Transaction and SWS Merger was 28%, 20% and 15%, 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 orders an updated appraisal of the fair value of the collateral. Because 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 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 December 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. 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 December 31, 2015 and 2014, the estimated fair value of covered OREO was $99.1 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 December 31, 2015 and 2014 was $0.4 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		Year Ended December 31,
December 31, 2015	Inputs		Inputs		Inputs		Fair Value		2015		2014		2013
Non-covered impaired loans	$	—	$	—	$	49,277	$	49,277	$	(126)	$	(2,182)	$	(3,558)
Covered impaired loans		—		—		58,135		58,135		3,034		(3,652)		—
Non-covered other real estate owned		—		—		—		—		(28)		(372)		430
Covered other real estate owned		—		36,024		—		36,024		(16,555)		(19,672)		—

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 measured at fair value on a recurring or non-recurring basis are discussed above. For other financial assets and liabilities, the Company utilizes quoted market prices, if available, to estimate the fair value of financial instruments. Because no quoted market prices exist for a significant portion of the Company’s financial instruments, the fair value of such instruments has been derived based on management’s assumptions with respect to future economic conditions, the amount and timing of future cash flows, and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the estimates provided herein do not necessarily indicate amounts which could be realized in a current transaction. Further, as it is management’s intent to hold a significant portion of its financial instruments to maturity, it is not probable that the fair values shown below will be realized in a current transaction.

Because of the wide range of permissible valuation techniques and the numerous estimates which must be made, it may be difficult to make reasonable comparisons of the Company’s fair value information to that of other financial institutions. The aggregate estimated fair value amount should in no way be construed as representative of the underlying value of Hilltop and its subsidiaries. The following methods and assumptions are typically used in estimating the fair value disclosures for financial instruments:

Cash and Cash Equivalents – For cash and due from banks and federal funds sold, the carrying amount is a reasonable estimate of fair value.

Securities Purchased Under Agreements to Resell – Securities purchased under agreements to resell are carried at the amounts at which the securities will subsequently be resold as specified in the agreements. The carrying amounts approximate fair value due to their short-term nature.

Assets Segregated for Regulatory Purposes – Assets segregated for regulatory purposes may consist of cash and securities with carrying amounts that approximate fair value.

Held to Maturity Securities – For securities held to maturity, estimated fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans Held for Sale – Loans held for sale consist primarily of certain mortgage loans held for sale that are subject to purchase by related parties. Such loans are reported at fair value, as discussed above, using Level 2 inputs that consist of commitments on hand from investors or prevailing market prices.

Loans – The fair value of non-covered and covered loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Broker-Dealer and Clearing Organization Receivables – The carrying amount approximates their fair value.

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.

Deposits – The estimated fair value of demand deposits, savings accounts and NOW accounts is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The carrying amount for variable-rate certificates of deposit approximates their fair values.

Broker-Dealer and Clearing Organization Payables – The carrying amount approximates their fair value.

Short-Term Borrowings – The carrying amounts of federal funds purchased, borrowings under repurchase agreements, Federal Home Loan Bank (“FHLB”) and other short-term borrowings approximate their fair values.

Debt – The fair values are estimated using discounted cash flow analysis based on current incremental borrowing rates for similar types of borrowing arrangements.

Other Assets and Liabilities – Other assets and liabilities primarily consists of cash surrender value of life insurance policies and accrued interest receivable and payable with carrying amounts that approximate their fair values using Level 2 inputs. The fair value of certain other receivables and investments is based on Level 3 inputs.

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
December 31, 2015	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	669,445	$	669,445	$	—	$	—	$	669,445
Securities purchased under agreements to resell		105,660		—		105,660		—		105,660
Assets segregated for regulatory purposes		158,613		158,613		—		—		158,613
Held to maturity securities		332,022		—		331,468		—		331,468
Loans held for sale		72,843		—		72,843		—		72,843
Non-covered loans, net		5,174,625		—		602,968		4,600,406		5,203,374
Covered loans, net		378,762		—		—		527,201		527,201
Broker-dealer and clearing organization receivables		1,362,499		—		1,362,499		—		1,362,499
FDIC indemnification asset		91,648		—		—		91,648		91,648
Other assets		68,786		—		53,214		15,572		68,786

Financial liabilities:
Deposits		6,952,683		—		6,955,919		—		6,955,919
Broker-dealer and clearing organization payables		1,338,305		—		1,338,305		—		1,338,305
Short-term borrowings		947,373		—		947,373		—		947,373
Debt		305,728		—		299,257		—		299,257
Other liabilities		3,699		—		3,699		—		3,699


			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
Assets segregated for regulatory purposes		76,013		76,013		—		—		76,013
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