Fair value is 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. There are three levels of inputs that may be used to measure fair values:

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 March 31, 2019 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Equity securities	$	6,235	$	6,235	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		9,777		9,777		—		—
U.S. government-sponsored entities and agencies		698,514		—		698,514		—
Mortgage-backed securities - Agency		2,560,703		—		2,560,703		—
States and political subdivisions		965,436		—		965,396		40
Pooled trust preferred securities		8,123		—		—		8,123
Other securities		327,219		30,640		296,579		—
Residential loans held for sale		14,082		—		14,082		—
Derivative assets		39,952		—		39,952		—
Financial Liabilities
Derivative liabilities		11,546		—		11,546		—

			Fair Value Measurements at December 31, 2018 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Equity securities	$	5,582	$	5,582	$	—	$	—
Investment securities available-for-sale:
U.S. Treasury		5,301		5,301		—		—
U.S. government-sponsored entities and agencies		628,151		—		628,151		—
Mortgage-backed securities - Agency		2,209,295		—		2,209,295		—
States and political subdivisions		940,429		—		936,321		4,108
Pooled trust preferred securities		8,495		—		—		8,495
Other securities		331,745		30,259		301,486		—
Residential loans held for sale		14,911		—		14,911		—
Derivative assets		29,005		—		29,005		—
Financial Liabilities
Derivative liabilities		12,550		—		12,550		—

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

	Pooled Trust			States and
	Preferred			Political
(dollars in thousands)	Securities			Subdivisions
Three Months Ended March 31, 2019
Balance at beginning of period	$	8,495		$	4,108
Accretion (amortization) of discount		4			—
Sales/payments received		(15	)		(35	)
Increase (decrease) in fair value of securities		(361	)		—
Transfers out of Level 3		—			(4,033	)
Balance at end of period	$	8,123		$	40

Three Months Ended March 31, 2018
Balance at beginning of period	$	8,448		$	—
Accretion of discount		5			—
Sales/payments received		(288	)		—
Increase (decrease) in fair value of securities		30			—
Transfers into Level 3		—			4,061
Balance at end of period	$	8,195		$	4,061

The accretion or amortization of discounts on securities in the table above is included in interest income. An 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. A decrease in fair value is reflected in the balance sheet as a decrease in the fair value of investment securities available-for-sale, a decrease in accumulated other comprehensive income, which is included in shareholders’ equity, and an increase in other assets related to the tax impact. During the three months ended March 31, 2019, Old National received third party pricing on a $4.0 million state and political subdivisions security and transferred it out of Level 3. Old National transferred a $4.1 million state and political subdivisions security to Level 3 during the three months ended March 31, 2018 because Old National could no longer obtain evidence of observable inputs.

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

Valuation

Unobservable

Range (Weighted

(dollars in thousands)

Fair Value

Techniques

Input

Average)

March 31, 2019

Pooled trust preferred securities

8,123

Discounted cash flow

Constant prepayment rate (a)

0.00%

Additional asset defaults (b)

3.6% - 4.2% (4.0%)

Expected asset recoveries (c)

0.00%

State and political subdivisions

Discounted cash flow

No observable inputs

N/A

Local municipality issuance

Old National owns 100%

Carried at par

December 31, 2018

Pooled trust preferred securities

8,495

Discounted cash flow

Constant prepayment rate (a)

0.00%

Additional asset defaults (b)

6.8% - 8.5% (7.3%)

Expected asset recoveries (c)

0.00%

State and political subdivisions

4,108

Discounted cash flow

No observable inputs

N/A

Local municipality issuance

Old National owns 100%

Carried at par

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 at March 31, 2019 are summarized below:

			Fair Value Measurements at March 31, 2019 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Collateral Dependent Impaired Loans:
Commercial loans	$	4,781	$	—	$	—	$	4,781
Commercial real estate loans		17,146		—		—		17,146
Foreclosed Assets:
Commercial		225		—		—		225
Loan servicing rights		93		—		93		—

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 $31.4 million, with a valuation allowance of $9.5 million at March 31, 2019. Old National recorded provision expense associated with these loans totaling $1.2 million for the three months ended March 31, 2019. Old National recorded provision recapture associated with impaired commercial and commercial real estate loans that were deemed collateral dependent totaling $1.6 million for the three months ended March 31, 2018.

Other real estate owned and other repossessed property is measured at fair value less costs to sell and had a net carrying amount of $0.2 million at March 31, 2019. 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 no write-downs of other real estate owned during the three months ended March 31, 2019 and $0.3 million during the three months ended March 31, 2018.

Loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value. Fair value is determined at a tranche level, based on market prices for comparable mortgage servicing contracts when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model utilizes a discount rate, weighted average prepayment speed, and other economic factors that market participants would use in estimating future net servicing income and that can be validated against available market data (Level 2). The valuation allowance for loan servicing rights with impairments at March 31, 2019 totaled $17 thousand. Old National recorded impairments associated with these loan servicing rights totaling $2 thousand during the three months ended March 31, 2019 and recoveries of $9 thousand for the three months ended March 31, 2018.

Assets measured at fair value on a non-recurring basis at December 31, 2018 are summarized below:

			Fair Value Measurements at December 31, 2018 Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Collateral Dependent Impaired Loans:
Commercial loans	$	7,242	$	—	$	—	$	7,242
Commercial real estate loans		29,125		—		—		29,125
Foreclosed Assets:
Residential		68		—		—		68
Loan servicing rights		104		—		104		—

At December 31, 2018, impaired commercial and commercial real estate loans had a principal amount of $49.3 million, with a valuation allowance of $12.9 million.

Other real estate owned and other repossessed property had a net carrying amount of $68 thousand at December 31, 2018.

The valuation allowance for loan servicing rights with impairments at December 31, 2018 totaled $15 thousand.

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

Valuation

Unobservable

Range (Weighted

(dollars in thousands)

Fair Value

Techniques

Input

Average)

March 31, 2019

Collateral Dependent Impaired

Loans

Commercial loans

4,781

Fair value of

Discount for type of property,

0% - 90% (41%)

collateral

age of appraisal, and current

status

Commercial real estate loans

17,146

Fair value of

Discount for type of property,

0% - 50% (35%)

collateral

age of appraisal and current

status

Foreclosed Assets

Commercial

225

Fair value of

Discount for type of property,

collateral

age of appraisal, and current status

December 31, 2018

Collateral Dependent Impaired

Loans

Commercial loans

7,242

Fair value of

Discount for type of property,

0% - 90% (35%)

collateral

age of appraisal, and current

status

Commercial real estate loans

29,125

Fair value of

Discount for type of property,

0% - 50% (35%)

collateral

age of appraisal and current

status

Foreclosed Assets

Residential

Fair value of

Discount for type of property,

15% - 16% (15%)

collateral

age of appraisal, and current status

Old National 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.

Old National has 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 $188 thousand for the three months ended March 31, 2019 and $22 thousand for the three months ended March 31, 2018.

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 at March 31, 2019 and December 31, 2018 was as follows:

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:

								Total Changes
								in Fair Values
	Other							Included in
	Gains and		Interest		Interest			Current Period
(dollars in thousands)	(Losses)		Income		(Expense)			Earnings
Three Months Ended March 31, 2019
Residential loans held for sale	$	90	$	5	$	—		$	95

Three Months Ended March 31, 2018
Residential loans held for sale	$	35	$	—	$	(4	)	$	31

The carrying amounts and estimated fair values of financial instruments not carried at fair value at March 31, 2019 and December 31, 2018 were as follows:

			Fair Value Measurements at March 31, 2019 Using
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Cash, due from banks, money market, and other interest-earning investments	$	323,116	$	323,116	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		74,195		—		74,186		—
Mortgage-backed securities - Agency		123,627		—		123,858		—
State and political subdivisions		287,012		—		295,833		—
Loans, net:
Commercial		3,022,384		—		—		2,961,284
Commercial real estate		4,998,451		—		—		4,915,521
Residential real estate		2,241,583		—		—		2,205,698
Consumer credit		1,751,000		—		—		1,715,516
Accrued interest receivable		86,279		34		25,225		61,020

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	3,903,314	$	3,903,314	$	—	$	—
Checking, NOW, savings, and money market interest-bearing deposits		8,464,358		8,464,358		—		—
Time deposits		2,061,598		—		2,046,438		—
Federal funds purchased and interbank borrowings		325,030		325,030		—		—
Securities sold under agreements to repurchase		342,480		342,480		—		—
FHLB advances		1,719,944		—		—		1,731,524
Other borrowings		251,584		—		254,441		—
Accrued interest payable		7,961		—		7,961		—
Standby letters of credit		482		—		—		482

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	4,105

			Fair Value Measurements at December 31, 2018 Using
			Quoted Prices in		Significant
			Active Markets		Other		Significant
			for Identical		Observable		Unobservable
	Carrying		Assets		Inputs		Inputs
(dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Cash, due from banks, money market, and other interest-earning investments	$	317,165	$	317,165	$	—	$	—
Investment securities held-to-maturity:
U.S. government-sponsored entities and agencies		73,986		—		72,359
Mortgage-backed securities - Agency		127,120		—		124,409		—
State and political subdivisions		305,228		—		309,335		—
Loans, net:
Commercial		3,211,228		—		—		3,161,132
Commercial real estate		4,935,381		—		—		4,781,294
Residential real estate		2,246,127		—		—		2,225,853
Consumer credit		1,795,695		—		—		1,773,352
Accrued interest receivable		89,464		13		27,580		61,871

Financial Liabilities
Deposits:
Noninterest-bearing demand deposits	$	3,965,380	$	3,965,380	$	—	$	—
Checking, NOW, savings, and money market interest-bearing deposits		8,360,313		8,360,313		—		—
Time deposits		2,024,256		—		2,002,187		—
Federal funds purchased and interbank borrowings		270,135		270,135		—		—
Securities sold under agreements to repurchase		362,294		362,294		—		—
FHLB advances		1,613,481		—		—		1,611,103
Other borrowings		247,883		—		248,065		—
Accrued interest payable		9,871		—		9,871		—
Standby letters of credit		525		—		—		525

Off-Balance Sheet Financial Instruments
Commitments to extend credit	$	—	$	—	$	—	$	3,115

The methods utilized to measure the fair value of financial instruments at March 31, 2019 and December 31, 2018 represent an approximation of exit price, however, an actual exit price may differ.