NOTE 21 - 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 December 31, 2016 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

4,982

—

Investment securities available-for-sale:

U.S. Treasury

7,103

—

U.S. government-sponsored entities and agencies

493,956

—

493,956

—

Mortgage-backed securities - Agency

1,525,019

—

1,525,019

—

States and political subdivisions

436,684

—

436,684

Pooled trust preferred securities

8,119

—

8,119

Other securities

326,293

30,905

295,388

—

Residential loans held for sale

90,682

—

90,682

—

Derivative assets

17,701

—

17,701

—

Financial Liabilities

Derivative liabilities

23,574

—

23,574

—


			Fair Value Measurements at December 31, 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	$	3,941	$	3,941	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		12,150		12,150		—		—
U.S. government-sponsored entities and agencies		613,550		—		613,550		—
Mortgage-backed securities - Agency		1,066,361		—		1,066,361		—
States and political subdivisions		387,296		—		387,296		—
Pooled trust preferred securities		7,900		—		—		7,900
Other securities		330,964		31,443		299,521		—
Residential loans held for sale		13,810		—		13,810		—
Derivative assets		15,925		—		15,925		—
Financial Liabilities
Derivative liabilities		26,968		—		26,968		—

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 year ended December 31, 2016:


(dollars in thousands)	Pooled Trust Preferred Securities Available-for-Sale
Balance at January 1, 2016	$	7,900
Accretion of discount		18
Sales/payments received		(327	)
Increase in fair value of securities		528

Balance at December 31, 2016	$	8,119

The accretion of discounts on securities totaling $18 thousand in 2016 is included in interest income. 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 year ended December 31, 2015:


(dollars in thousands)	Pooled Trust Preferred Securities Available-for-Sale			State and Political Subdivisions
Balance at January 1, 2015	$	6,607		$	325
Accretion of discount		18			—
Sales/payments received		(663	)		—
Matured securities		—			(325	)
Increase in fair value of securities		1,938			—

Balance at December 31, 2015	$	7,900		$	—

The accretion of discounts on securities totaling $18 thousand in 2015 is included in interest income. 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 provide 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
Dec. 31, 2016

Valuation
Techniques

Unobservable

Input

Range (Weighted
Average)

Pooled trust preferred securities

8,119

Discounted cash flow

Constant prepayment rate (a)

0.00%

Additional asset defaults (b)

4.5% - 10.0% (7.9%)

Expected asset recoveries (c)

0.0% - 6.1% (0.9%)

(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, 2015

Valuation
Techniques

Unobservable

Input

Range (Weighted
Average)

Pooled trust preferred securities

7,900

Discounted cash flow

Constant prepayment rate (a)

0.00%

Additional asset defaults (b)

4.1% - 11.5% (8.1%)

Expected asset recoveries (c)

0.0% - 11.5% (3.1%)

(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%.

Significant changes in any of the unobservable inputs used in the fair value measurement 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 are summarized below:

Fair Value Measurements at December 31, 2016 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

6,771

—

6,771

Commercial real estate loans

11,632

—

11,632

Foreclosed Assets

Commercial real estate

1,352

—

1,352

Residential

394

—

394

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 $26.4 million, with a valuation allowance of $8.0 million at December 31, 2016. Old National recorded provision recapture associated with these loans totaling $1.1 million in 2016.

Other real estate owned and other repossessed property is measured at fair value less costs to sell and had a net carrying amount of $1.7 million at December 31, 2016. 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 $3.0 million in 2016.

Assets measured at fair value on a non-recurring basis at December 31, 2015 are summarized below:


			Fair Value Measurements at December 31, 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	$	13,332	$	—	$	—	$	13,332
Commercial real estate loans		11,857		—		—		11,857
Foreclosed Assets
Commercial real estate		2,526		—		—		2,526
Residential		203		—		—		203

As of December 31, 2015, impaired commercial and commercial real estate loans had a principal amount of $36.8 million, with a valuation allowance of $11.5 million. Old National recorded provision expense associated with these loans totaling $4.7 million in 2015.

Other real estate owned and other repossessed property had a net carrying amount of $2.7 million at December 31, 2015. There were write-downs of other real estate owned of $2.2 million in 2015.

The tables below provide 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
Dec. 31, 2016

Valuation
Techniques

Unobservable
Input

Range (Weighted
Average)

Collateral Dependent Impaired Loans

Commercial loans

6,771

Fair value of
collateral

Discount for type of property, age of appraisal and current status

0% - 99% (53%)

Commercial real estate loans

11,632

Fair value of
collateral

Discount for type of property, age of appraisal and current status

10% - 67% (36%)

Foreclosed Assets

Commercial real estate

1,352

Fair value of
collateral

Discount for type of property, age of appraisal and current status

4% - 80% (39%)

Residential

394

Fair value of
collateral

Discount for type of property, age of appraisal and current status

7% - 60% (30%)

(dollars in thousands)

Fair Value at
Dec. 31, 2015

Valuation
Techniques

Unobservable
Input

Range (Weighted
Average)

Collateral Dependent Impaired Loans

Commercial loans

13,332

Fair value of
collateral

Discount for type of property, age of appraisal, and current status

0% - 86% (28%)

Commercial real estate loans

11,857

Fair value of
collateral

Discount for type of property, age of appraisal, and current status

0% - 61% (33%)

Foreclosed Assets

Commercial real estate

2,526

Fair value of
collateral

Discount for type of property, age of appraisal, and current status

3% - 80% (26%)

Residential

203

Fair value of
collateral

Discount for type of property, age of appraisal, and current status

7% - 53% (29%)

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 $0.1 million in 2016 and 2015.

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 December 31, 2016 and 2015 was as follows:


(dollars in thousands)	Aggregate Fair Value		Difference		Contractual Principal
2016
Residential loans held for sale	$	90,682	$	133	$	90,549

2015
Residential loans held for sale	$	13,810	$	236	$	13,574

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 years ended December 31:


(dollars in thousands)	Other Gains and (Losses)			Interest Income		Interest (Expense)		Total Changes in Fair Values Included in Current Period Earnings
2016
Residential loans held for sale	$	(103	)	$	—	$	—	$	(103	)

2015
Residential loans held for sale	$	(140	)	$	—	$	—	$	(140	)

The carrying amounts and estimated fair values of financial instruments, not previously presented in this note, at December 31, 2016 and 2015 were as follows:

Fair Value Measurements at December 31, 2016 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

255,519

—

Investment securities held-to-maturity:

U.S. government-sponsored entities and agencies

40,131

—

40,558

—

Mortgage-backed securities—Agency

10,640

—

10,940

—

State and political subdivisions

694,319

—

732,674

—

Federal Home Loan Bank/Federal Reserve Bank stock

101,716

N/A

Loans, net:

Commercial

1,895,618

—

1,971,296

Commercial real estate

3,112,680

—

3,400,365

Residential real estate

2,085,887

—

2,228,542

Consumer credit

1,866,519

—

1,974,180

Accrued interest receivable

81,381

22,880

58,485

Financial Liabilities

Deposits:

Noninterest-bearing demand deposits

3,016,093

—

NOW, savings, and money market deposits

6,259,052

—

Time deposits

1,468,108

—

1,460,778

—

Federal funds purchased and interbank borrowings

213,003

Securities sold under agreements to repurchase

367,052

317,052

50,612

—

Federal Home Loan Bank advances

1,353,092

—

1,360,599

Other borrowings

218,939

—

217,647

—

Accrued interest payable

5,979

—

5,979

—

Standby letters of credit

315

—

315

Off-Balance Sheet Financial Instruments

Commitments to extend credit

—

2,527

N/A = not applicable


	Carrying Value		Fair Value Measurements at December 31, 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	$	219,818	$	219,818	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		142,864		—		145,763		—
Mortgage-backed securities - Agency		16,042		—		16,604		—
State and political subdivisions		713,205		—		767,050		—
Federal Home Loan Bank/Federal Reserve Bank stock		86,146		N/A		N/A		N/A
Loans, net (including covered loans):
Commercial		1,788,593		—		—		1,829,824
Commercial real estate		1,852,979		—		—		1,946,163
Residential real estate		1,659,284		—		—		1,745,248
Consumer credit		1,595,316		—		—		1,587,879
FDIC indemnification asset		9,030		—		—		5,700
Accrued interest receivable		69,098		29		22,821		46,248

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	2,488,855	$	2,488,855	$	—	$	—
NOW, savings, and money market deposits		4,911,938		4,911,938		—		—
Time deposits		1,000,067		—		998,878		—
Federal funds purchased and interbank borrowings		291,090		291,090		—		—
Securities sold under agreements to repurchase		387,409		337,409		51,370		—
Federal Home Loan Bank advances		1,023,491		—		—		1,029,779
Other borrowings		218,256		—		201,138		—
Accrued interest payable		4,859		—		4,859		—
Standby letters of credit		429		—		—		429

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	2,364

N/A = not applicable

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 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 is our basis because it is not practical to determine the fair value due to restrictions placed on transferability.

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). The method utilized to estimate the fair value of loans does not necessarily represent an exit price.

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 was not contractually embedded in the assets and was not transferable with the assets should we have chosen 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 were 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).

Federal funds purchased and interbank borrowings: Federal funds purchased and interbank 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).

Securities sold under agreements to repurchase: The fair value of securities sold under agreements to repurchase is determined using end of day market prices (Level 1 or Level 2).

Federal Home Loan Bank advances: The fair value of FHLB advances is determined using calculated prices for new FHLB advances with similar risk characteristics (Level 3).

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 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 (Level 3). For further information regarding the amounts of these financial instruments, see Notes 23 and 24.