NOTE 22 – FAIR VALUE

FASB ASC 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820-10 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair values:

•

Level 1 – Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

•

Level 2 – Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

•

Level 3 – Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Old National used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using swap and LIBOR curves plus spreads that adjust for loss severities, volatility, credit risk, and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Residential loans held for sale: The fair value of loans held for sale is determined using quoted prices for a similar asset, adjusted for specific attributes of that loan (Level 2).

Derivative financial instruments: The fair values of derivative financial instruments are based on derivative valuation models using market data inputs as of the valuation date (Level 2).

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which we have elected the fair value option, are summarized below:

Fair Value Measurements at September 30, 2015 Using

(dollars in thousands)

Carrying
Value

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

Significant
Other
Observable
Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)

Financial Assets

Trading securities

3,827

—

Investment securities available-for-sale:

U.S. Treasury

12,239

—

U.S. government-sponsored entities and agencies

641,780

—

641,780

—

Mortgage-backed securities - Agency

1,136,352

—

1,136,352

—

States and political subdivisions

390,103

—

390,103

—

Pooled trust preferred securities

6,631

—

6,631

Other securities

332,788

31,676

301,112

—

Residential loans held for sale

18,783

—

18,783

—

Derivative assets

20,727

—

20,727

—

Financial Liabilities

Derivative liabilities

36,295

—

36,295

—


			Fair Value Measurements at December 31, 2014 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Financial Assets
Trading securities	$	3,881	$	3,881	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		15,166		15,166		—		—
U.S. government-sponsored entities and agencies		685,951		—		685,951		—
Mortgage-backed securities - Agency		1,241,662		—		1,241,662		—
States and political subdivisions		314,541		—		314,216		325
Pooled trust preferred securities		6,607		—		—		6,607
Other securities		363,904		31,648		332,256		—
Residential loans held for sale		15,562		—		15,562		—
Derivative assets		18,572		—		18,572		—
Financial Liabilities
Derivative liabilities		23,868		—		23,868		—

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended September 30, 2015:


(dollars in thousands)	Pooled Trust Preferred Securities Available-for-Sale			State and Political Subdivisions
Balance at January 1, 2015	$	6,607		$	325
Accretion/(amortization) of discount or premium		14			—
Sales/payments received		(536	)		—
Matured securities		—			(325	)
Increase/(decrease) in fair value of securities		546			—

Balance at September 30, 2015	$	6,631		$	—

Included in the income statement for the nine months ended September 30, 2015 is $14 thousand of income included in interest income from the accretion of discounts on securities. The increase in fair value is reflected in the balance sheet as an increase in the fair value of investment securities available-for-sale, an increase in accumulated other comprehensive income, which is included in shareholders’ equity, and a decrease in other assets related to the tax impact.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended September 30, 2014:


(dollars in thousands)	Pooled Trust Preferred Securities Available-for-Sale			State and Political Subdivisions
Balance at January 1, 2014	$	8,037		$	669
Accretion/(amortization) of discount or premium		13			1
Payments received		(1,054	)		(11	)
Matured securities		—			(335	)
Increase/(decrease) in fair value of securities		149			—

Balance at September 30, 2014	$	7,145		$	324

Included in the income statement for the nine months ended September 30, 2014 is $14 thousand of income included in interest income from the accretion of discounts on securities. The increase in fair value is reflected in the balance sheet as an increase in the fair value of investment securities available-for sale, an increase in accumulated other comprehensive income, which is included in shareholders’ equity, and a decrease in other assets related to the tax impact.

The tables below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 of the fair value hierarchy as of September 30, 2015 and December 31, 2014:


(dollars in thousands)	Fair Value at Sept. 30, 2015		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Pooled trust preferred securities	$	6,631	Discounted cash flow	Constant prepayment rate (a)	0.00%
				Additional asset defaults (b)	3.3% - 4.4% (4.1%)
				Expected asset recoveries (c)	0.0% - 15.6% (4.1%)

(a)	Assuming no prepayments.

(b)	Each currently performing pool asset is assigned a default probability based on the banking environment, which is adjusted for specific issuer evaluation, of 0%, 50% or 100%.

(c)	Each currently defaulted pool asset is assigned a recovery probability based on specific issuer evaluation of 0%, 25% or 100%.


(dollars in thousands)	Fair Value at Dec. 31, 2014		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Pooled trust preferred securities	$	6,607	Discounted cash flow	Constant prepayment rate (a)	0.00%
				Additional asset defaults (b)	4.4% - 11.2% (8.2%)
				Expected asset recoveries (c)	0.7% - 7.0% (1.8%)
State and political subdivision securities		325	Discounted cash flow	No unobservable inputs	N/A
				Illiquid local municipality issuance
				Old National owns 100%
				Carried at par

(a)	Assuming no prepayments.

(b)	Each currently performing pool asset is assigned a default probability based on the banking environment, which is adjusted for specific issuer evaluation, of 0%, 50% or 100%.

(c)	Each currently defaulted pool asset is assigned a recovery probability based on specific issuer evaluation of 0%, 25% or 100%.

The significant unobservable inputs used in the fair value measurement for pooled trust preferred securities are prepayment rates, assumed additional pool asset defaults, and expected return to performing status of defaulted pool assets. Significant changes in any of the inputs in isolation would result in a significant change to the fair value measurement. The pooled trust preferred securities Old National owns are subordinate note classes that rely on an ongoing cash flow stream to support their values. The senior note classes receive the benefit of prepayments to the detriment of subordinate note classes since the ongoing interest cash flow stream is reduced by the early redemption. Generally, a change in prepayment rates or additional pool asset defaults has an impact that is directionally opposite from a change in the expected recovery of a defaulted pool asset.

Assets measured at fair value on a non-recurring basis at September 30, 2015 are summarized below:

Fair Value Measurements at September 30, 2015 Using

(dollars in thousands)

Carrying
Value

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

Significant
Other
Observable
Inputs
(Level 2)

Significant
Unobservable
Inputs
(Level 3)

Collateral Dependent Impaired Loans

Commercial loans

22,519

—

22,519

Commercial real estate loans

17,913

—

17,913

Foreclosed Assets

Commercial real estate

2,619

—

2,619

Residential

108

—

108

Impaired commercial and commercial real estate loans that are deemed collateral dependent are valued based on the fair value of the underlying collateral. These estimates are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property, and other related factors to estimate the current value of the collateral. These impaired commercial and commercial real estate loans had a principal amount of $51.8 million, with a valuation allowance of $11.4 million at September 30, 2015. Old National recorded provision recapture associated with these loans totaling $3.6 million for the three months ended September 30, 2015 and provision expense of $4.0 million for the nine months ended September 30, 2015. Old National recorded provision expense associated with these loans totaling $2.8 million for the three months ended September 30, 2014 and provision expense of $5.4 million for the nine months ended September 30, 2014.

Other real estate owned and other repossessed property is measured at fair value less costs to sell and had a net carrying amount of $2.7 million at September 30, 2015. The estimates of fair value are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property and other related factors to estimate the current value of the collateral. There were write-downs of other real estate owned of $0.3 million for the three months ended September 30, 2015 and $1.8 million for the nine months ended September 30, 2015. There were write-downs of other real estate owned of $0.6 million for the three months ended September 30, 2014 and $2.4 million for the nine months ended September 30, 2014.

Assets measured at fair value on a non-recurring basis at December 31, 2014 are summarized below:


			Fair Value Measurements at December 31, 2014 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Collateral Dependent Impaired Loans
Commercial loans	$	6,816	$	—	$	—	$	6,816
Commercial real estate loans		13,011		—		—		13,011
Foreclosed Assets
Commercial real estate		6,146		—		—		6,146
Residential		254		—		—		254

As of December 31, 2014, impaired commercial and commercial real estate loans had a principal amount of $30.0 million, with a valuation allowance of $10.2 million.

Other real estate owned and other repossessed property is measured at fair value less costs to sell and had a net carrying amount of $6.4 million at December 31, 2014.

The tables below provides quantitative information about significant unobservable inputs used in fair value measurements within Level 3 of the fair value hierarchy:


(dollars in thousands)	Fair Value at Sept. 30, 2015		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Collateral Dependent Impaired Loans
Commercial loans	$	22,519	Fair value of collateral	Discount for type of property, age of appraisal and current status	0% - 86% (30%)
Commercial real estate loans		17,913	Fair value of collateral	Discount for type of property, age of appraisal and current status	10% - 74% (31%)
Foreclosed Assets
Commercial real estate		2,619	Fair value of collateral	Discount for type of property, age of appraisal and current status	2% - 80% (29%)
Residential		108	Fair value of collateral	Discount for type of property, age of appraisal and current status	22% - 37% (31%)


(dollars in thousands)	Fair Value at Dec. 31, 2014		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Collateral Dependent Impaired Loans
Commercial loans	$	6,816	Fair value of collateral	Discount for type of property, age of appraisal and current status	0% - 94% (24%)
Commercial real estate loans		13,011	Fair value of collateral	Discount for type of property, age of appraisal and current status	0% - 50% (29%)
Foreclosed Assets
Commercial real estate		6,146	Fair value of collateral	Discount for type of property, age of appraisal and current status	2% - 93% (30%)
Residential		254	Fair value of collateral	Discount for type of property, age of appraisal and current status	8% - 81% (45%)

Collateral dependent loans, other real estate owned and other repossessed property are valued based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property, and other related factors to estimate the current value of the collateral. These appraisals are discounted depending on the type of property and the type of appraisal (market value vs. liquidation value).

Financial instruments recorded using fair value option

Under FASB ASC 825-10, we may elect to report most financial instruments and certain other items at fair value on an instrument-by instrument basis with changes in fair value reported in net income. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability or firm commitment or when certain specified reconsideration events occur. The fair value election may not be revoked once an election is made.

We have elected the fair value option for residential loans held for sale. For these loans, interest income is recorded in the consolidated statements of income based on the contractual amount of interest income earned on the financial assets (except any that are on nonaccrual status). None of these loans are 90 days or more past due, nor are any on nonaccrual status. Included in the income statement is interest income for loans held for sale totaling $33 thousand for the three months ended September 30, 2015 and $118 thousand for the nine months ended September 30, 2015. Included in the income statement is interest income for loans held for sale totaling $143 thousand for the three months ended September 30, 2014 and $268 thousand for the nine months ended September 30, 2014.

Residential loans held for sale

Old National has elected the fair value option for newly originated conforming fixed-rate and adjustable-rate first mortgage loans held for sale. These loans are intended for sale and are hedged with derivative instruments. Old National has elected the fair value option to mitigate accounting mismatches in cases where hedge accounting is complex and to achieve operational simplification. The fair value option was not elected for loans held for investment.

The difference between the aggregate fair value and the aggregate remaining principal balance for loans for which the fair value option has been elected as of September 30, 2015 and December 31, 2014 is as follows:


(dollars in thousands)	Aggregate Fair Value		Difference		Contractual Principal
September 30, 2015
Residential loans held for sale	$	18,783	$	511	$	18,272

December 31, 2014
Residential loans held for sale	$	15,562	$	375	$	15,187

Accrued interest at period end is included in the fair value of the instruments.

The following table presents the amount of gains and losses from fair value changes included in income before income taxes for financial assets carried at fair value for the three and nine months ended September 30:


(dollars in thousands)	Other Gains and (Losses)		Interest Income			Interest (Expense)		Total Changes in Fair Values Included in Current Period Earnings
Three months ended September 30, 2015
Residential loans held for sale	$	350	$	(1	)	$	—	$	349

Three months ended September 30, 2014
Residential loans held for sale	$	32	$	4		$	—	$	36

Nine months ended September 30, 2015
Residential loans held for sale	$	137	$	(1	)	$	—	$	136

Nine months ended September 30, 2014
Residential loans held for sale	$	305	$	5		$	—	$	310

The carrying amounts and estimated fair values of financial instruments, not previously presented in this note, at September 30, 2015 and December 31, 2014 are as follows:


			Fair Value Measurements at September 30, 2015 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Financial Assets
Cash, due from banks, federal funds sold and money market investments	$	173,410	$	173,410	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		143,694		—		147,855		—
Mortgage-backed securities - Agency		17,782		—		18,506		—
State and political subdivisions		689,575		—		735,815		—
Federal Home Loan Bank/Federal Reserve Bank stock		86,146		—		86,146		—
Loans, net (including covered loans):
Commercial		1,725,291		—		—		1,776,187
Commercial real estate		1,854,105		—		—		1,959,627
Residential real estate		1,656,215		—		—		1,750,510
Consumer credit		1,561,061		—		—		1,561,905
FDIC indemnification asset		8,905		—		—		7,130
Accrued interest receivable		65,485		75		21,713		43,697

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	2,388,854	$	2,388,854	$	—	$	—
NOW, savings and money market deposits		5,245,278		5,245,278		—		—
Time deposits		987,193		—		991,415		—
Short-term borrowings:
Federal funds purchased		109,188		109,188		—		—
Repurchase agreements		365,706		365,706		—		—
Other borrowings:
Senior unsecured bank notes		175,000		—		165,370		—
Junior subordinated debentures		45,000		—		33,037		—
Repurchase agreements		50,000		—		51,848		—
Federal Home Loan Bank advances		849,419		—		—		857,890
Capital lease obligation		4,052		—		5,421		—
Accrued interest payable		3,064		—		3,064		—
Standby letters of credit		386		—		—		386

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	3,003


			Fair Value Measurements at December 31, 2014 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Financial Assets
Cash, due from banks, federal funds sold and money market investments	$	239,963	$	239,963	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		167,207		—		173,486		—
Mortgage-backed securities - Agency		23,648		—		24,574		—
State and political subdivisions		653,199		—		705,875		—
Federal Home Loan Bank/Federal Reserve Bank stock		71,175		—		71,175		—
Loans held for sale (a)		197,928		—		197,928		—
Loans, net (including covered loans):
Commercial		1,626,097		—		—		1,646,144
Commercial real estate		1,734,559		—		—		1,744,126
Residential real estate		1,537,448		—		—		1,615,588
Consumer credit		1,372,248		—		—		1,380,835
FDIC indemnification asset		20,603		—		—		11,358
Accrued interest receivable		60,966		29		21,633		39,304

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	2,427,748	$	2,427,748	$	—	$	—
NOW, savings and money market deposits		4,973,898		4,973,898		—		—
Time deposits		1,089,018		—		1,092,969		—
Short-term borrowings:
Federal funds purchased		195,188		195,188		—		—
Repurchase agreements		356,121		356,120		—		—
Other borrowings:
Senior unsecured bank notes		175,000		—		179,792		—
Junior subordinated debentures		45,000		—		32,754		—
Repurchase agreements		50,000		—		51,994		—
Federal Home Loan Bank advances		649,987		—		—		658,506
Capital lease obligation		4,099		—		5,515		—
Accrued interest payable		4,564		—		4,564		—
Standby letters of credit		358		—		—		358

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	2,030

(a)	Includes loans held for sale associated with branch sales. Excludes $15.6 million of residential loans held for sale measured at fair value on a recurring basis.

The following methods and assumptions were used to estimate the fair value of each type of financial instrument.

Cash, due from banks, federal funds sold and resell agreements, and money market investments: For these instruments, the carrying amounts approximate fair value (Level 1).

Investment securities: Fair values for investment securities held-to-maturity are based on quoted market prices, if available. For securities where quoted prices are not available, fair values are estimated based on market prices of similar securities (Level 2).

Federal Home Loan Bank and Federal Reserve Bank stock: Old National Bank is a member of the FHLB and the Federal Reserve System. The carrying value approximates the fair value based on the redemption provisions of the stock (Level 2).

Loans held for sale: The fair value of loans held for sale is estimated based on binding contracts from third party investors (Level 2).

Loans: The fair value of loans is estimated by discounting future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities (Level 3).

Covered loans: Fair values for loans were based on a discounted cash flow methodology that considered factors including the type of loan and related collateral, classification status, fixed or variable interest rate, term of loan and whether or not the loan was amortizing, and a discount rate reflecting current market rates for new originations of comparable loans adjusted for the risk inherent in the cash flow estimates. Loans were grouped together according to similar characteristics and were treated in the aggregate when applying various valuation techniques (Level 3).

FDIC indemnification asset: The loss sharing asset was measured separately from the related covered assets as it is not contractually embedded in the assets and is not transferable with the assets should we choose to dispose of the assets. Fair value was originally estimated using projected cash flows related to the loss sharing agreement based on the expected reimbursements for losses and the applicable loss sharing percentage and these projected cash flows are updated with the cash flow estimates on covered assets. These cash flows were discounted to reflect the uncertainty of the timing and receipt of the loss sharing reimbursement from the FDIC (Level 3).

Accrued interest receivable and payable: The carrying amount approximates fair value and is aligned with the underlying assets or liabilities (Level 1, Level 2 or Level 3).

Deposits: The fair value of noninterest-bearing demand deposits and savings, NOW, and money market deposits is the amount payable as of the reporting date (Level 1). The fair value of fixed-maturity certificates of deposit is estimated using rates currently offered for deposits with similar remaining maturities (Level 2).

Short-term borrowings: Federal funds purchased and other short-term borrowings generally have an original term to maturity of 30 days or less and, therefore, their carrying amount is a reasonable estimate of fair value (Level 1). The fair value of securities sold under agreements to repurchase is determined using end of day market prices (Level 1).

Other borrowings: The fair value of medium-term notes, subordinated debt, and senior bank notes is determined using market quotes (Level 2). The fair value of FHLB advances is determined using calculated prices for new FHLB advances with similar risk characteristics (Level 3). The fair value of other debt is determined using comparable security market prices or dealer quotes (Level 2).

Standby letters of credit: Fair values for standby letters of credit are based on fees currently charged to enter into similar agreements. The fair value for standby letters of credit was recorded in “Accrued expenses and other liabilities” on the consolidated balance sheet in accordance with FASB ASC 460-10 (FIN 45) (Level 3).

Off-balance sheet financial instruments: Fair values for off-balance sheet credit-related financial instruments are based on fees currently charged to enter into similar agreements. For further information regarding the amounts of these financial instruments, see Notes 19 and 20.