Fair Value:

Fair value estimates are determined as of a specific date using quoted market prices, where available, or various assumptions and estimates. As the assumptions underlying these estimates change, the fair value of the financial instruments will change. The use of assumptions and various valuation techniques, as well as the absence of secondary markets for certain financial instruments, will likely reduce the comparability of fair value disclosures between financial institutions. Accordingly, the aggregate fair value amounts presented do not represent and should not be construed to represent the full underlying value of Sterling.

The carrying amounts and fair values of financial instruments as of the periods indicated were as follows. Other assets are comprised of FHLB stock and derivatives, while other liabilities are comprised of derivatives:



		December 31, 2013				December 31, 2012
	Level	Carrying Amount		Fair Value		Carrying Amount		Fair Value
		(in thousands)
Financial assets:
Cash and cash equivalents	1	$	545,435	$	545,435	$	331,550	$	331,550
Investments and MBS:
Available for sale	2	1,429,812		1,429,812		1,513,157		1,513,157
Held to maturity	2	165		165		206		206
Loans held for sale	2	138,952		138,952		465,983		465,983
Loans receivable, net	3	7,331,228		7,344,637		6,101,749		6,154,296
Mortgage servicing rights, net	3	60,100		75,017		32,420		32,420
Other assets (1)	2	99,756		99,756		108,642		108,642
Financial liabilities:
Non-maturity deposits	2	5,373,544		5,373,544		4,697,147		4,697,147
Deposits with stated maturities	2	1,701,446		1,717,039		1,738,970		1,768,818
Borrowings	2	1,923,081		1,845,614		1,437,491		1,457,911
Other liabilities	2	516		516		4,025		4,025

(1) Other assets includes FHLB stock. As of December 31, 2013 and December 31, 2012, FHLB stock was carried at $95.3 million and $97.5 million, respectively.

Companies have the option of carrying financial assets and liabilities at fair value, which can be implemented on all or individually selected financial instruments. The framework for defining and measuring fair value requires that one of three valuation methods be used to determine fair market value: the market approach, the income approach or the cost approach. To increase consistency and comparability in fair value measurements and related disclosures, the standard also creates a fair value hierarchy to prioritize the inputs to these valuation methods into the following three levels:


•	Level 1 inputs are a select class of observable inputs, based upon the quoted prices for identical instruments in active markets that are accessible as of the measurement date, and are to be used whenever available.


•	Level 2 inputs are other types of observable inputs, such as quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are inactive; or other inputs that are observable or can be derived from or supported by observable market data. Level 2 inputs are to be used whenever Level 1 inputs are not available.


•	Level 3 inputs are substantially unobservable, reflecting the reporting entity's own assumptions regarding what market participants would assume when pricing a financial instrument. Level 3 inputs are to be used only when Level 1 and Level 2 inputs are unavailable.

The methods and assumptions used to estimate the fair value of certain financial instruments are as follows:

Cash and Cash Equivalents. The carrying value of cash and cash equivalents approximates fair value due to the relatively short-term nature of these instruments.

Investments and MBS. The fair value of investments and MBS are provided by a third-party pricing service. These valuations are based on market data using pricing models that vary by asset class and incorporate available current trade, bid and other market information, and for structured securities, cash flow and loan performance data. The pricing processes utilize benchmark curves, benchmarking of similar securities, sector groupings, and matrix pricing. Option adjusted spread models are also used to assess the impact of changes in interest rates and to develop prepayment scenarios. All models and processes used take into account market convention.

Loans Held for Sale. Sterling has elected to carry residential loans held for sale at fair value. The fair values of residential loans are based on investor quotes in the secondary market, determined by the fair value of options and commitments to sell or issue mortgage loans. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination. Nonresidential loans held for sale are carried at the lower of cost or market ("LOCOM") due to the frequency of these loan sale transactions, as well as the availability of market data for these loan types.

Loans Receivable. The fair value of performing loans is estimated by discounting the cash flows using interest rates that consider the current credit and interest rate risk inherent in the loans and current economic and lending conditions and does not incorporate the exit price concept of fair value. Certain residential mortgage loans that were previously classified as held for sale are carried at fair value because at origination Sterling elected to carry these loans at fair value. The fair value of these loans is based on current market rates with various discounts applied to each individual loan. The fair value of nonperforming collateral-dependent loans is estimated based upon the value of the underlying collateral. The fair value of other nonperforming loans is estimated by discounting management's current estimate of future cash flows using a rate estimated to be commensurate with the risks involved. Changes in the various inputs in the fair value of nonperforming loans will have a significant impact on the fair value.

Mortgage Servicing Rights. The fair value of mortgage servicing rights is estimated using a discounted cash flow model to arrive at the net present value of expected earnings from the servicing of the loans. Model inputs include prepayment speeds, market interest rates, contractual interest rates on the loans being serviced, the amount of other fee income generated and other factors. The fair value of mortgage servicing rights is impacted by any changes in these inputs.

Deposits. The fair values of deposits subject to immediate withdrawal such as interest and noninterest bearing checking, regular savings, and money market deposit accounts, are equal to the amounts payable on demand at the reporting date. Fair values for time deposits are estimated by discounting future cash flows using interest rates currently offered on time deposits with similar remaining maturities.

Borrowings. The carrying amounts of short-term borrowings under repurchase agreements, federal funds purchased, short-term FHLB advances and other short-term borrowings approximate their fair values due to the relatively short period of time between the origination of the instruments and the expected payment dates on the instruments. The fair value of long-term FHLB advances and other long-term borrowings is estimated using discounted cash flow analysis based on Sterling's current incremental borrowing rates for similar types of borrowing arrangements with similar remaining terms.

Derivatives. Interest rate lock commitments and forward commitments valuations are estimated using quoted market prices for similar instruments. Fair values for the interest rate swaps are based on the present value differential between the fixed interest rate payments and the floating interest rate payments as projected by the forward interest rate curve, over the term of the swap, with the recorded amount net of any credit valuation adjustments.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents Sterling's financial instruments that are measured at fair value on a recurring basis:



	Total		Level 1		Level 2		Level 3
	(in thousands)
December 31, 2013
Investment securities available for sale:
MBS	$	1,239,900	$	0	$	1,239,900	$	0
Municipal bonds	189,690		0		189,690		0
Other	222		0		222		0
Total investment securities available for sale	1,429,812		0		1,429,812		0
Loans held for sale	138,952		0		138,952		0
Loans receivable, net	26,462		0		0		26,462
Other assets - derivatives	4,479		0		4,479		0
Total assets	$	1,599,705	$	0	$	1,573,243	$	26,462
Other liabilities - derivatives	516		0		516		0
Total liabilities	$	516	$	0	$	516	$	0
December 31, 2012
Investment securities available for sale:
MBS	$	1,308,838	$	0	$	1,308,838	$	0
Municipal bonds	204,306		0		204,306		0
Other	13		0		13		0
Total investment securities available for sale	1,513,157		0		1,513,157		0
Loans held for sale	465,983		0		465,983		0
Loans receivable, net	23,177		0		0		23,177
Other assets - derivatives	11,183		0		11,183		0
Total assets	$	2,013,500	$	0	$	1,990,323	$	23,177
Contingent consideration	15,442		$	0	$	0	$	15,442
Other liabilities - derivatives	4,025		0		4,025		0
Other liabilities - derivatives	$	19,467	$	0	$	4,025	$	15,442

The following table presents the changes in fair value for loans receivable measured at fair value on a recurring basis using Level 3 inputs:



	Years Ended December 31,
	2013			2012
	(in thousands)
Beginning balance	$	23,177		$	12,776
Transfers from held for sale	16,060			14,450
Principal payments and payoffs	(11,511		)	(3,515		)
Valuation adjustments	(1,264		)	(534		)
Ending balance	$	26,462		$	23,177

Differences between the aggregate fair value and the aggregate unpaid principal balance of loans receivable carried at fair value were $1.3 million, and $534,000 during the years ended December 31, 2013, and 2012, respectively, and were included in income from mortgage banking operations. Valuation adjustments were based on current market rates for comparable loans, in addition to discounts applied based on specific loan characteristics.

Contingent consideration represents the estimated liability for additional payments related to the First Independent transaction based on the application of a discounted cash flow methodology. The following table presents a roll-forward of contingent consideration.



	Years Ended December 31,
	2013			2012
	(in thousands)
Beginning balance	$	15,442		$	0
Additions	0			11,700
Valuation adjustments	1,395			3,742
Payout	(16,837		)	0
Ending balance	$	0		$	15,442

Valuation adjustments are included in noninterest expense within merger and acquisition expense. The final contingent consideration payment was made in the third quarter of 2013.

Derivatives include mortgage banking interest rate lock and loan delivery commitments, and interest rate swaps. See Note 11 for a further discussion of these derivatives. The differences between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale that are carried at fair value were included in earnings as follows:



	Years Ended December 31,
	2013			2012
	(in thousands)
Mortgage banking operations	$	(17,299	)	$	11,447

Assets and Liabilities Measured at Fair Value on a Non-recurring Basis

Sterling may be required to measure certain assets at fair value on a non-recurring basis from application of LOCOM accounting or write-downs of individual assets. The following table presents the carrying value for these assets as of the dates indicated:



	December 31, 2013
	Total Carrying Value		Level 1		Level 2		Level 3		Gains (Losses) During the Year Ended December 31, 2013
	(in thousands)
Loans	$	118,037	$	0	$	0	$	118,037	$	(15,352	)
OREO	522		0		0		522		(930		)
Mortgage servicing rights	60,100		0		0		60,100		6,948
	December 31, 2012								Losses During the Year Ended December 31, 2012
	Total Carrying Value		Level 1		Level 2		Level 3		Losses During the Year Ended December 31, 2012
	(in thousands)
Loans	$	172,172	$	0	$	0	$	172,172	$	(27,649	)
OREO	18,074		0		0		18,074		(1,296		)
Mortgage servicing rights	32,420		0		0		32,420		(230		)

The loans disclosed above represent the net balance of loans as of period end that have been individually evaluated for impairment during the years ended December 31, 2013 and 2012, with the losses comprised of charge-offs and increases in the specific reserve. OREO represents the carrying value of properties for which a specific reserve was recorded during the periods presented as a result of updated appraisals subsequent to foreclosure. The appraisals may use comparable sales and income approach valuation methods and may be adjusted to reflect current market or property information. In addition to the loan and OREO losses disclosed above, charge-offs at foreclosure for properties held as of period end totaled $884,000 and $3.9 million for the years ended December 31, 2013 and 2012, respectively. Fair value adjustments to the mortgage servicing rights were mainly due to market derived assumptions associated with mortgage prepayment speeds. Sterling carries its mortgage servicing rights at LOCOM, and they are accordingly measured at fair value on a non-recurring basis. Qualitative information regarding the fair value measurements for Level 3 financial instruments are as follows:



	December 31, 2013
	Method	Inputs
Loans	Income, Market, Comparable Sales, Discounted Cash Flows	External appraised values; probability weighting of broker price opinions; management assumptions regarding market trends or other relevant factors; selling costs ranging from 4.5% to 9%.
OREO	Income, Market, Comparable Sales, Discounted Cash Flows	External appraised values; probability weighting of broker price opinions; management assumptions regarding market trends or other relevant factors; selling costs ranging from 4.5% to 9%.
Mortgage servicing rights	Discounted Cash Flow	Weighted average prepayment speed: residential 9.3%, commercial 11.7%; weighted average discount rate: residential 10.2%, commercial 15.7%.