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 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 September 30, 2017 and December 31, 2016, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.86 billion and $1.75 billion, respectively, and the unpaid principal balance of those loans was $1.79 billion and $1.71 billion, respectively. 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 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
September 30, 2017	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	3,526	$	672,885	$	—	$	676,411
Available for sale securities		20,983		744,559		—		765,542
Loans held for sale		—		1,828,275		31,545		1,859,820
Derivative assets		—		55,563		—		55,563
MSR asset		—		—		47,766		47,766
Securities sold, not yet purchased		85,471		88,038		—		173,509
Derivative liabilities		—		17,500		—		17,500


	Level 1		Level 2		Level 3			Total
December 31, 2016	Inputs		Inputs		Inputs			Fair Value
Trading securities	$	9,481	$	256,053	$	—	$	265,534
Available for sale securities		19,840		578,167		—		598,007
Loans held for sale		—		1,712,697		35,801		1,748,498
Derivative assets		—		57,036		—		57,036
MSR asset		—		—		61,968		61,968
Securities sold, not yet purchased		60,715		93,174		—		153,889
Derivative liabilities		—		35,737		—		35,737

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 September 30, 2017
Loans held for sale	$	30,037	$	8,881	$	(5,685)	$	(1,688)	$	—	$	31,545
MSR asset		43,580		5,939		—		(1,753)		—		47,766
Total	$	73,617	$	14,820	$	(5,685)	$	(3,441)	$	—	$	79,311

Nine months ended September 30, 2017
Loans held for sale	$	35,801	$	25,384	$	(23,108)	$	(6,532)	$	—	$	31,545
MSR asset		61,968		8,429		(17,499)		(5,132)		—		47,766
Total	$	97,769	$	33,813	$	(40,607)	$	(11,664)	$	—	$	79,311

Three months ended September 30, 2016
Trading securities	$	1	$	—	$	—	$	(1)	$	—	$	—
Loans held for sale		45,645		8,066		(8,686)		(2,448)		—		42,577
MSR asset		33,491		10,416		—		(156)		—		43,751
Total	$	79,137	$	18,482	$	(8,686)	$	(2,605)	$	—	$	86,328

Nine months ended September 30, 2016
Trading securities	$	1	$	—	$	—	$	(1)	$	—	$	—
Loans held for sale		25,880		51,105		(23,817)		(10,591)		—		42,577
MSR asset		52,285		20,309		(7,586)		(21,257)		—		43,751
Total	$	78,166	$	71,414	$	(31,403)	$	(31,849)	$	—	$	86,328

All net realized and unrealized gains (losses) in the table above are reflected in the accompanying consolidated financial statements. Excluding the trading securities sold during the three months ended September 30, 2016, the unrealized gains (losses) relate to financial instruments still held at September 30, 2017.

For Level 3 financial instruments measured at fair value on a recurring basis at September 30, 2017, the significant unobservable inputs used in the fair value measurements were as follows.


			Range
Financial instrument	Valuation Technique	Unobservable Inputs	(Weighted-Average)
Loans held for sale	Discounted cash flows / Market comparable	Projected price	90	-	95	%	(	95	%)

MSR asset	Discounted cash flows	Constant prepayment rate			10.85		%
		Discount rate			11.07		%

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 inputs. The fair values of such loans are 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.

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 tables present those changes in fair value of instruments recognized in the consolidated statements of operations that are accounted for under the Fair Value Option (in thousands).


	Three Months Ended September 30, 2017						Three Months Ended September 30, 2016
			Other		Total				Other		Total
	Net		Noninterest		Changes in		Net		Noninterest		Changes in
	Gains (Losses)		Income		Fair Value		Gains (Losses)		Income		Fair Value
Loans held for sale	$	(4,443)	$	—	$	(4,443)	$	73	$	—	$	73
MSR asset		(1,753)		—		(1,753)		(156)		—		(156)


	Nine Months Ended September 30, 2017						Nine Months Ended September 30, 2016
			Other		Total				Other		Total
	Net		Noninterest		Changes in		Net		Noninterest		Changes in
	Gains (Losses)		Income		Fair Value		Gains (Losses)		Income		Fair Value
Loans held for sale	$	26,650	$	—	$	26,650	$	16,003	$	—	$	16,003
MSR asset		(5,132)		—		(5,132)		(21,257)		—		(21,257)

The Company also determines the fair value of certain assets and liabilities on a non-recurring basis. 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. Purchased credit impaired (“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 PCC (the “PlainsCapital Merger”), the FDIC-assisted transaction whereby the Bank acquired certain assets and assumed certain liabilities of Edinburg, Texas-based First National Bank (“FNB”) on September 13, 2013 (the “FNB Transaction”), and the acquisition of SWS Group, Inc. (“SWS”) in a stock and cash transaction (the "SWS Merger"), whereby SWS’s banking subsidiary, Southwest Securities, FSB was merged into the Bank, 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 September 30, 2017, estimates for these significant unobservable inputs were as follows.


	PCI Loans
	PlainsCapital		FNB		SWS
	Merger		Transaction		Merger
Weighted average default rate	64	%	45	%	59	%
Weighted average loss severity rate	66	%	18	%	29	%
Weighted average prepayment speed	0	%	8	%	0	%

At September 30, 2017, the resulting weighted average expected loss on PCI loans associated with the PlainsCapital Merger, FNB Transaction and SWS Merger was 43%, 8% and 17%, 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 other real estate owned (“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 September 30, 2017, 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 September 30, 2017 and December 31, 2016, the estimated fair value of covered OREO was $40.3 million and $51.6 million, respectively, and the underlying fair value measurements utilized Level 2 and Level 3 inputs. The fair value of non-covered OREO at September 30, 2017 and December 31, 2016 was $4.8 million and $4.5 million, respectively, and is included in other assets within the consolidated balance sheets. 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				Total Gains (Losses) for the
	Level 1		Level 2		Level 3		Total		Three Months Ended September 30,				Nine Months Ended September 30,
September 30, 2017	Inputs		Inputs		Inputs		Fair Value		2017		2016		2017		2016
Non-covered impaired loans	$	—	$	—	$	42,953	$	42,953	$	793	$	1,149	$	323	$	1,284
Covered impaired loans		—		—		58,490		58,490		(787)		725		(1,764)		815
Non-covered other real estate owned		—		3,512		—		3,512		(135)		(427)		(258)		(439)
Covered other real estate owned		—		6,969		—		6,969		(388)		(2,552)		(2,523)		(14,284)

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. There have been no changes to the methods for determining estimated fair value for financial assets and liabilities which are described in detail in Note 3 to the consolidated financial statements included in the Company’s 2016 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
September 30, 2017	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	354,969	$	354,969	$	—	$	—	$	354,969
Securities purchased under agreements to resell		134,654		—		134,654		—		134,654
Assets segregated for regulatory purposes		207,336		207,336		—		—		207,336
Held to maturity securities		368,031		—		364,122		—		364,122
Loans held for sale		79,501		—		79,501		—		79,501
Non-covered loans, net		6,090,034		—		485,604		5,802,891		6,288,495
Covered loans, net		188,269		—		—		284,424		284,424
Broker-dealer and clearing organization receivables		1,672,123		—		1,672,123		—		1,672,123
FDIC indemnification asset		33,143		—		—		22,866		22,866
Other assets		64,907		—		59,300		5,607		64,907

Financial liabilities:
Deposits		7,663,447		—		7,662,392		—		7,662,392
Broker-dealer and clearing organization payables		1,517,698		—		1,517,698		—		1,517,698
Short-term borrowings		1,477,201		—		1,477,201		—		1,477,201
Debt		367,208		—		364,731		—		364,731
Other liabilities		6,630		—		6,630		—		6,630


			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
December 31, 2016	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	690,764	$	690,764	$	—	$	—	$	690,764
Securities purchased under agreements to resell		89,430		—		89,430		—		89,430
Assets segregated for regulatory purposes		180,993		180,993		—		—		180,993
Held to maturity securities		351,831		—		345,088		—		345,088
Loans held for sale		46,965		—		46,965		—		46,965
Non-covered loans, net		5,789,313		—		502,077		5,459,975		5,962,052
Covered loans, net		255,714		—		—		367,444		367,444
Broker-dealer and clearing organization receivables		1,497,741		—		1,497,741		—		1,497,741
FDIC indemnification asset		71,313		—		—		60,173		60,173
Other assets		62,904		—		58,697		4,207		62,904

Financial liabilities:
Deposits		7,063,811		—		7,058,837		—		7,058,837
Broker-dealer and clearing organization payables		1,347,128		—		1,347,128		—		1,347,128
Short-term borrowings		1,417,289		—		1,417,289		—		1,417,289
Debt		384,924		—		378,822		—		378,822
Other liabilities		3,708		—		3,708		—		3,708