Fair Value Measurements

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined using quoted market prices. However, in many instances, quoted market prices are not available. In such instances, fair values are determined using various valuation techniques. Various assumptions and observable inputs must be relied upon in applying these techniques. Accordingly, the fair value estimates may not be realized in an immediate transfer of the respective asset or liability.

Fair Value Hierarchy

The three levels within the fair value hierarchy are as follows:


•	Level 1: Valuation is based upon unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

•

Level 2: Fair value is calculated using inputs other than quoted market prices that are directly or indirectly observable for the asset or liability. The valuation may rely on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit ratings, etc.) or inputs that are derived principally or corroborated by market data by correlation or other means.


•	Level 3: Inputs for determining the fair value of the respective assets or liabilities are not observable. Level 3 valuations are reliant upon pricing models and techniques that require significant management judgment or estimation.

Categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Securities

When quoted prices are available in an active market, the Company classifies securities within Level 1 of the valuation hierarchy. Level 1 securities include equity securities in financial institutions and U.S. Treasury Bills.

If quoted market prices are not available, the Company employs an independent pricing service that utilizes matrix pricing to calculate fair value. Such fair value measurements consider observable data such as dealer quotes, market spreads, cash flows, yield curves, live trading levels, trade execution data, market consensus prepayments speeds, credit information, and respective terms and conditions for debt instruments. The Company employs procedures to monitor the pricing service's assumptions and establishes processes to challenge the pricing service's valuations that appear unusual or unexpected. Level 2 securities include agency CMOs, CLOs, corporate debt, single-issuer trust preferred securities, agency mortgage-backed securities, commercial mortgage backed securities and auction rate preferred securities.

When a market is illiquid or there is a lack of transparency around the inputs to valuation, the securities are classified as Level 3 and reliance is placed upon internally developed models, and management judgment and evaluation for valuation.

Pooled trust preferred securities are currently classified as Level 3. Due to the continued inactive market and illiquid nature of pooled trust preferred securities in the entire capital structure, an internal cash flow model is used to value these securities on a quarterly basis. The Company employs an internal CDO model for projection of future cash flows and discounting those cash flows to a net present value. Each underlying issuer in the pool is rated internally using the latest financial data on each institution, and future deferrals, defaults and losses are then estimated on the basis of continued stress in the financial markets. Further, all current and projected deferrals are not assumed to cure, and all current and projected defaults are assumed to have no recovery value. The resulting net cash flows are then discounted at current market levels for similar types of products that are actively trading.

Alternative Investments

The Company generally accounts for its percentage ownership of alternative investment funds at cost, subject to impairment testing, while certain funds are included at fair value based upon the net asset value of the respective fund. At June 30, 2013, alternative investments consisted of $1.4 million recorded at fair value and $11.2 million recorded at cost. These are non-public investments that cannot be redeemed since the Company’s investment is distributed as the underlying investments are liquidated, which generally takes 10 years. There are currently no plans to sell any of these investments prior to their liquidation. The alternative investments included at fair value are classified within Level 3 of the fair value hierarchy. The alternative investments that are carried at cost are considered to be measured at fair value on a non-recurring basis when there is impairment. The Company has $5.0 million in unfunded commitments remaining for its alternative investments as of June 30, 2013.

Investments Held in Rabbi Trust

The investments held in a Rabbi Trust primarily include mutual funds that invest in equity and fixed income securities. Shares of mutual funds are valued based on net asset value, which represents quoted market prices for the underlying shares held in the mutual funds. Therefore, investments held in Rabbi Trust are classified within Level 1 of the fair value hierarchy. The Company has elected to measure the investments held in Rabbi Trust at fair value. The Company consolidates the invested assets of the trust along with the total deferred compensation obligations and includes them in other assets and other liabilities, respectively, in the accompanying Condensed Consolidated Balance Sheets. Earnings in the Rabbi Trust, including appreciation or depreciation, are reflected as other non-interest income and changes in the corresponding liability are reflected as compensation and benefits in the accompanying Condensed Consolidated Statements of Income. At June 30, 2013, the cost basis of the investments held in the Rabbi Trust is $5.1 million.

Derivative Instruments

Derivative instruments are valued using third-party valuation software which consider the present value of cash flows discounted using observable forward rate assumptions. The resulting fair values are validated against valuations performed by independent third parties and are classified within Level 2 of the fair value hierarchy. Fed funds futures contracts are valued based on unadjusted quoted prices in active markets and are classified within Level 1 of the fair value hierarchy. In determining if any fair value adjustments related to credit risk are required, the Company evaluates the credit risk of its counterparties by considering factors such as the likelihood of default by the Company and its counterparties, its net exposures, the remaining contractual life, as well as the amount of collateral securing the position. The Company reviews its counterparty exposure on a regular basis, and, when necessary, appropriate business actions are taken to adjust the exposure. When determining fair value, the Company applies the portfolio exception with respect to measuring counterparty credit risk for all of its derivative transactions subject to a master netting arrangement. To date, the Company has not realized any losses due to a counterparty's inability to pay any net uncollateralized position. The change in value of derivative assets and liabilities attributable to credit risk was not significant during the reported periods.

Mortgage Banking Derivatives

Mortgage-backed securities are utilized by Webster in its efforts to manage risk of loss associated with its mortgage loan commitments and mortgage loans held for sale. Prior to closing and funding certain single-family residential mortgage loans, an interest rate lock commitment is generally extended to the borrower. During the period from commitment date to closing date, Webster is subject to the risk that market rates of interest may change. If market rates rise, investors generally will pay less to purchase such loans resulting in a reduction in the gain on sale of the loans or, possibly, a loss. In an effort to mitigate such risk, forward delivery sales commitments, under which Webster agrees to deliver whole mortgage loans to various investors or issue mortgage-backed securities, are established.

A summary of fair values for assets and liabilities measured at fair value on a recurring basis is as follows:



	At June 30, 2013
(In thousands)	Carrying Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial assets held at fair value:
Available for sale securities:
U.S. Treasury Bills	$	200	$	200	$	—	$	—
Agency CMOs	1,003,897		—		1,003,897		—
Agency MBS	1,338,192		—		1,338,192		—
CMBS	440,136		—		440,136		—
CLOs	278,008		—		278,008		—
Pooled trust preferred securities	30,215		—		—		30,215
Single issuer trust preferred securities	44,875		—		44,875		—
Corporate debt	112,671		—		112,671		—
Equity securities	9,166		8,891		275		—
Total available for sale securities	3,257,360		9,091		3,218,054		30,215
Derivative instruments:
Interest rate swaps	37,298		—		37,298		—
Fed Fund futures contracts	141		141		—		—
Mortgage banking derivatives	5,084		—		5,084		—
Investments held in Rabbi Trust	5,604		5,604		—		—
Investments in private equity funds	1,357		—		—		1,357
Total financial assets held at fair value	$	3,306,844	$	14,836	$	3,260,436	$	31,572
Financial liabilities held at fair value:
Derivative instruments:
Interest rate swaps	$	24,433	$	—	$	24,433	$	—
Total financial liabilities held at fair value	$	24,433	$	—	$	24,433	$	—



	At December 31, 2012
(In thousands)	Carrying Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial assets held at fair value:
Available for sale securities:
U.S. Treasury Bills	$	200	$	200	$	—	$	—
Agency CMOs	1,310,006		—		1,310,006		—
Agency MBS	1,142,280		—		1,142,280		—
CMBS	398,031		—		398,031		—
CLOs	88,540		—		—		88,540
Pooled trust preferred securities	26,207		—		—		26,207
Single issuer trust preferred securities	44,415		—		44,415		—
Corporate debt	118,199		—		118,199		—
Equity securities	8,282		8,082		200		—
Total available for sale securities	3,136,160		8,282		3,013,131		114,747
Derivative instruments:
Interest rate swaps	50,969		—		50,969		—
Mortgage banking derivatives	2,898		—		2,898		—
Investments held in Rabbi Trust	5,741		5,741		—		—
Investments in private equity funds	1,533		—		—		1,533
Total financial assets held at fair value	$	3,197,301	$	14,023	$	3,066,998	$	116,280
Financial liabilities held at fair value:
Derivative instruments:
Interest rate swaps	$	43,172	$	—	$	43,172	$	—
Fed Fund futures contracts	125		125		—		—
Visa swap	4		—		4		—
Total financial liabilities held at fair value	$	43,301	$	125	$	43,176	$	—

The following table presents the changes in Level 3 assets and liabilities that are measured at fair value on a recurring basis:



	Three months ended June 30,						Six months ended June 30,
(In thousands)	2013			2012			2013			2012
Level 3, beginning of period	$	280,582		$	32,062		$	116,280		$	32,814
Transfers out of Level 3 ^{(1) (2)}	(248,844		)	—			(248,844		)	(975		)
Change in unrealized loss included in other comprehensive income	1,643			(434		)	7,000			692
Unrealized loss included in net income	(20		)	98			(285		)	(622		)
Purchases/capital calls	109			—			159,412			126
Accretion/amortization	146			22			188			16
Calls/paydowns	(2,044		)	(772		)	(2,179		)	(1,075		)
Level 3, end of period	$	31,572		$	30,976		$	31,572		$	30,976

(1)

As of April 1, 2013, the CLO portfolio was transferred from Level 3 to Level 2 based on having more observable inputs in determining fair value. In prior quarters, the CLO portfolio was priced using average non-binding broker quotes. During the current quarter, the Company engaged a third-party pricing vendor to provide monthly fair value measurements. This methodology used is a combination of matrix pricing, observed market activity and metrics. Pricing inputs such as credit spreads are observable and market corroborated and, therefore, the CLO portfolio qualifies for Level 2 categorization. The market for these CLO's is an active market and there is ample price transparency.


(2)	As of January 1, 2012, auction rate preferred securities were transferred from Level 3 to Level 2. These securities are considered to be Level 2 based upon observable market activity at full par value for recent transactions.

The following table presents information about quantitative inputs and assumptions for items categorized in Level 3 of the fair value hierarchy:



	At June 30, 2013
(Dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Range of Inputs (Weighted Average)
Pooled trust preferred securities	$	30,215	Discounted cash flow	Discount rate	5.91 - 9.01% (8.21%)
				Credit spread	246-556 bps (476 bps)

Discount rates are derived for each security depending on the original rating or a notched down rating based on management's judgment. The discount represents a market rate used to discount expected cash flows to determine the fair value of the security. Components of the calculated discount rate are the twelve month rolling average of published industry credit spreads and the 30 year swap rate. When discount rates increase as a result of an increase in rate or credit spread, there is a direct inverse correlation with fair value; as discount rates increase, fair value decreases. An increase in credit spreads correlates to an increase in discount rate and, therefore, a decrease in fair value.

Pooled trust preferred security issuer financials are reviewed on a quarterly basis and an internal credit rating (“shadow rating”) is updated for individual issuers in the model. The shadow rating is correlated to a Moody’s loss table to determine the loss impact on expected cash flows. There is a direct relationship between shadow rating and fair value; as shadow ratings decline the loss probability increases, expected cash flows decline and, therefore, fair value decreases. There may be instances when a one notch downgrade in an individual issuers credit ratings may not significantly impact the fair value of securities.

Assets Measured at Fair Value on a Non-Recurring Basis

Certain assets are measured at fair value on a non-recurring basis; that is, the assets are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following is a description of valuation methodologies used for assets measured on a non-recurring basis.

Impaired Loans and Leases

Impaired loans and leases for which repayment of the loan or lease is expected to be provided solely by the value of the underlying collateral are considered collateral dependent and are valued based on the estimated fair value of such collateral using Level 3 inputs based on customized discounting criteria.

Loans Held for Sale

Loans held for sale are accounted for at the lower of cost or market and are considered to be recognized at fair value when they are recorded at below cost. The fair value of loans held for sale is based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted as required for changes in loan characteristics and are classified within Level 3 of the fair value hierarchy.

Other Real Estate Owned (OREO) and Repossessed Assets

The total book value of OREO and repossessed assets is $3.8 million at June 30, 2013. OREO and repossessed assets are accounted for at the lower of cost or market and are considered to be recognized at fair value when they are recorded at below cost. The fair value of OREO is based on independent appraisals or internal valuation methods, less estimated selling costs. The fair value of repossessed assets is based on available pricing guides, auction results and price opinions, less estimated selling costs. Certain assets require assumptions about factors that are not observable in an active market in the determination of fair value and are classified as Level 3.

Mortgage Servicing Assets

The Company accounts for mortgage servicing assets at cost, subject to impairment testing. When the carrying cost exceeds fair value, a valuation allowance is established to reduce the carrying cost to fair value. Fair value is calculated as the present value of estimated future net servicing income and relies on market based assumptions for loan prepayment speeds, servicing costs, discount rates, and other economic factors. As such, mortgage servicing assets are classified within Level 3 of the fair value hierarchy.

The table below presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis:



	At June 30, 2013
(Dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Range of Inputs
Impaired Loans	$	42,194	Real Estate Appraisals	Discount for dated appraisal	0% - 30%
				Discount for costs to sell	3.0% - 8.0%
Other Real Estate	$	3,050	Appraisals	Discount for costs to sell	8%
				Discount for appraisal type	25% - 30%
Mortgage Servicing Rights	$	23,384	Discounted cash flow	Constant prepayment rate	6.0% - 25.6%
				Discount Rates	3.9% - 6.7%

Assets and Liabilities Disclosed at Fair Value

The Company is required to disclose the estimated fair value of financial instruments, both assets and liabilities, for which it is practicable to estimate fair value. The following is a description of valuation methodologies used for those assets and liabilities.

Cash, Due from Banks, and Interest-bearing Deposits

The carrying amount of cash, due from banks, and interest-bearing deposits is used to approximate fair value, given the short time frame to maturity and, as such, assets do not present unanticipated credit concerns. Cash, due from banks, and interest-bearing deposits are classified within Level 1 of the fair value hierarchy.

Loan and Lease Receivables

The estimated fair value of loans and leases held for investment is calculated using a discounted cash flow method, using future prepayments and market interest rates inclusive of an illiquidity premium for comparable loans. The associated cash flows are adjusted for credit and other potential losses. Fair value for impaired loans and leases is estimated using the net present value of the expected cash flows. Loan and lease receivables are classified within Level 3 of the fair value hierarchy.

Deposit Liabilities

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Deposit liabilities are classified within Level 2 of the fair value hierarchy.

Securities Sold Under Agreements to Repurchase and Other Borrowings

Carrying value is an estimate of fair value for those securities sold under agreements to repurchase and other borrowings that mature within 90 days. The fair values of all other borrowings are estimated using discounted cash flow analyses based on current market rates adjusted, as appropriate, for associated credit risks. Securities sold under agreements to repurchase and other borrowings are classified within Level 2 of the fair value hierarchy.

Federal Home Loan Bank Advances and Long-Term Debt

The fair value of long-term debt is estimated using a discounted cash flow technique. Discount rates are matched with the time period of the expected cash flow and are adjusted, as appropriate, to reflect credit risk. Long-term debt and Federal Home Loan Bank advances are classified within Level 2 of the fair value hierarchy.

A summary of estimated fair values of significant financial instruments consisted of the following:



	At June 30, 2013
(In thousands)	Carrying Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Securities available for sale	$	3,257,360	$	9,091	$	3,218,054	$	30,215
Securities held-to-maturity	3,129,864		—		3,174,148		—
Loans held for sale	81,161		—		—		81,161
Loans and leases, net	12,082,851		—		—		12,183,704
Mortgage servicing assets (a)	18,764		—		—		23,384
Investments in private equity funds	12,587		—		—		12,587
Derivative instruments	37,439		141		37,298		—
Investments held in Rabbi Trust	5,604		5,604		—		—
Liabilities
Deposits other than time deposits	12,494,979		—		12,494,979		—
Time deposits	2,340,596		—		2,364,139		—
Securities sold under agreements to repurchase and other borrowings	1,213,349		—		1,247,264		—
Federal Home Loan Bank advances (b)	1,627,516		—		1,636,387		—
Long-term debt (c)	229,928		—		221,146		—
Derivative instruments	24,433		—		24,433		—



	At December 31, 2012
(In thousands)	Carrying Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Securities available for sale	$	3,136,160	$	8,282	$	3,013,131	$	114,747
Securities held-to-maturity	3,107,529		—		3,264,718		—
Loans held for sale	107,633		—		—		107,633
Loans and leases, net	11,851,567		—		—		12,005,555
Mortgage servicing assets (a)	14,027		—		—		15,881
Investments in private equity funds	11,623		—		—		11,623
Derivative instruments	50,969		—		50,969		—
Investments held in Rabbi Trust	5,741		5,741		—		—
Liabilities
Deposits other than time deposits	11,985,683		—		11,985,683		—
Time deposits	2,545,152		—		2,584,921		—
Securities sold under agreements to repurchase and other borrowings	1,076,160		—		1,134,614		—
Federal Home Loan Bank advances (b)	1,827,612		—		1,843,615		—
Long-term debt (c)	334,276		—		298,807		—
Derivative instruments	43,301		125		43,176		—


(a)	The carrying amount of mortgage servicing assets is net of $0.5 million and $1.8 million reserves at June 30, 2013 and December 31, 2012, respectively. The estimated fair value does not include such adjustments.


(b)	The carrying amount of FHLB advances is net of $73 thousand and $85 thousand in unamortized premiums at June 30, 2013 and December 31, 2012, respectively. The estimated fair value does not include such adjustments.


(c)	The carrying amount of long-term debt is net of $2.7 million and $4.4 million in hedge accounting adjustments and discounts at June 30, 2013 and December 31, 2012, respectively. The estimated fair value does not include such adjustments.

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings or any part of a particular financial instrument. Because no active market exists for a significant portion of Webster’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These factors are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.