4. 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 includes 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, 2018 and December 31, 2017, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.39 billion and $1.58 billion, respectively, and the unpaid principal balance of those loans was $1.35 billion and $1.53 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 fair value of loans held for sale is determined using an exit price method.

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, 2018	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	2,341	$	657,973	$	—	$	660,314
Available for sale securities		—		874,496		—		874,496
Equity securities		21,555		—		—		21,555
Loans held for sale		—		1,333,257		54,365		1,387,622
Derivative assets		—		45,979		—		45,979
MSR asset		—		—		68,804		68,804
Securities sold, not yet purchased		116,965		62,617		—		179,582
Derivative liabilities		—		15,291		—		15,291


	Level 1		Level 2		Level 3			Total
December 31, 2017	Inputs		Inputs		Inputs			Fair Value
Trading securities	$	3,329	$	727,356	$	—	$	730,685
Available for sale securities		—		744,319		—		744,319
Equity securities		21,241		—		—		21,241
Loans held for sale		—		1,544,631		36,972		1,581,603
Derivative assets		—		34,150		—		34,150
MSR asset		—		—		54,714		54,714
Securities sold, not yet purchased		156,586		76,235		—		232,821
Derivative liabilities		—		13,197		—		13,197

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, 2018
Loans held for sale	$	40,781	$	19,156	$	(4,614)	$	(958)	$	—	$	54,365
MSR asset		57,373		11,361		—		70		—		68,804
Total	$	98,154	$	30,517	$	(4,614)	$	(888)	$	—	$	123,169

Nine months ended September 30, 2018
Loans held for sale	$	36,972	$	39,706	$	(17,127)	$	(5,186)	$	—	$	54,365
MSR asset		54,714		21,090		(9,303)		2,303		—		68,804
Total	$	91,686	$	60,796	$	(26,430)	$	(2,883)	$	—	$	123,169

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

All net realized and unrealized gains (losses) in the tables above are reflected in the accompanying consolidated financial statements. The unrealized gains (losses) relate to financial instruments still held at September 30, 2018.

For Level 3 financial instruments measured at fair value on a recurring basis at September 30, 2018, 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	92	-	96	%	(	95	%)

MSR asset	Discounted cash flows	Constant prepayment rate			9.15		%
		Discount rate			11.11		%

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 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.

The MSR asset, which is included in other assets within the Company’s consolidated balance sheets, is reported at fair value using Level 3 inputs. The MSR asset 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 8 to the consolidated financial statements.

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

The following table presents 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, 2018						Three Months Ended September 30, 2017
			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	$	(20,417)	$	—	$	(20,417)	$	(4,443)	$	—	$	(4,443)
MSR asset		70		—		70		(1,753)		—		(1,753)


	Nine Months Ended September 30, 2018						Nine Months Ended September 30, 2017
			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	$	(12,693)	$	—	$	(12,693)	$	26,650	$	—	$	26,650
MSR asset		2,303		—		2,303		(5,132)		—		(5,132)

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 individually 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, $73.5 million and $7.5 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”), 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, and the BORO Acquisition, respectively (collectively, the “Bank Transactions”). Substantially all PCI loans acquired in the FNB Transaction were 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, 2018, estimates for these significant unobservable inputs were as follows.


	PCI Loans
	PlainsCapital		FNB		SWS		BORO
	Merger		Transaction		Merger		Acquisition
Weighted average default rate	83	%	35	%	70	%	63	%
Weighted average loss severity rate	67	%	13	%	28	%	45	%
Weighted average prepayment speed	0	%	6	%	0	%	0	%

At September 30, 2018, the resulting weighted average expected loss on PCI loans associated with the PlainsCapital Merger, FNB Transaction, SWS Merger and BORO Acquisition was 55%, 5%, 20% and 26%, 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 inputs. In the FNB Transaction, the Bank acquired OREO of $135.2 million, all of which were covered by FDIC loss-share agreements. At September 30, 2018 and December 31, 2017, the estimated fair value of covered OREO was $29.9 million and $36.7 million, respectively, and the underlying fair value measurements utilized Level 2 inputs. The fair value of non-covered OREO at September 30, 2018 and December 31, 2017 was $2.7 million and $3.9 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, 2018	Inputs		Inputs		Inputs		Fair Value		2018		2017		2018		2017
Non-covered impaired loans	$	—	$	—	$	17,749	$	17,749	$	(15)	$	793	$	(1,486)	$	323
Covered impaired loans		—		—		63,194		63,194		683		(787)		1,429		(1,764)
Non-covered other real estate owned		—		529		—		529		(91)		(135)		(167)		(258)
Covered other real estate owned		—		19,555		—		19,555		(303)		(388)		(2,027)		(2,523)

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. In accordance with ASU 2016-01, effective January 1, 2018, the fair values of non-covered and covered loans are measured using an exit price method. There have been no other changes to the methods for determining estimated fair value for financial assets and liabilities as described in detail in Note 3 to the consolidated financial statements included in the Company’s 2017 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, 2018	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	406,150	$	406,150	$	—	$	—	$	406,150
Assets segregated for regulatory purposes		220,115		220,115		—		—		220,115
Securities purchased under agreements to resell		164,656		—		164,656		—		164,656
Held to maturity securities		348,163		—		332,388		—		332,388
Loans held for sale		137,358		—		137,358		—		137,358
Non-covered loans, net		6,737,417		—		593,276		6,240,441		6,833,717
Covered loans, net		142,737		—		—		217,503		217,503
Broker-dealer and clearing organization receivables		1,491,507		—		1,491,507		—		1,491,507
FDIC indemnification asset		22,831		—		—		22,831		22,831
Other assets		70,998		—		69,940		1,058		70,998

Financial liabilities:
Deposits		8,290,233		—		8,279,098		—		8,279,098
Broker-dealer and clearing organization payables		1,396,401		—		1,396,401		—		1,396,401
Short-term borrowings		1,216,649		—		1,216,649		—		1,216,649
Debt		287,204		—		284,921		—		284,921
Other liabilities		6,032		—		6,032		—		6,032


			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
December 31, 2017	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	487,382	$	487,382	$	—	$	—	$	487,382
Assets segregated for regulatory purposes		186,578		186,578		—		—		186,578
Securities purchased under agreements to resell		186,537		—		186,537		—		186,537
Held to maturity securities		355,849		—		349,939		—		349,939
Loans held for sale		133,754		—		133,754		—		133,754
Non-covered loans, net		6,212,712		—		577,889		5,828,868		6,406,757
Covered loans, net		179,400		—		—		269,386		269,386
Broker-dealer and clearing organization receivables		1,464,378		—		1,464,378		—		1,464,378
FDIC indemnification asset		29,340		—		—		20,122		20,122
Other assets		64,862		—		59,053		5,809		64,862

Financial liabilities:
Deposits		7,978,119		—		7,973,101		—		7,973,101
Broker-dealer and clearing organization payables		1,287,563		—		1,287,563		—		1,287,563
Short-term borrowings		1,206,424		—		1,206,424		—		1,206,424
Debt		275,821		—		289,719		—		289,719
Other liabilities		4,795		—		4,795		—		4,795

The Company held equity investments other than securities of $42.8 million and $38.7 million at September 30, 2018 and December 31, 2017, respectively, which are included within other assets in the consolidated balance sheets. Of the $42.8 million of such equity investments held at September 30, 2018, $26.4 million do not have readily determinable fair values and each is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. The following table presents the adjustments to the carrying value of these investments (in thousands).


	Three months ended,		Nine months ended,
	September 30, 2018		September 30, 2018
Balance, beginning of period	$	26,151	$	22,946
Additional investments		—		1,411
Upward adjustments		265		3,642
Impairments and downward adjustments		(1)		(1,584)
Dispositions		—		—
Balance, end of period	$	26,415	$	26,415