INTERMOUNTAIN COMMUNITY BANCORP - 10-Q filing on 2012-11-13

Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2012

11. Fair Value of Financial Instruments:

Intermountain is required to required to disclose the estimated fair value of financial instruments, both assets and liabilities on and off the balance sheet, for which it is practicable to estimate fair value. These fair value estimates are made at September 30, 2012 based on relevant market information and information about the financial instruments. Fair value estimates are intended to represent the price an asset could be sold at or the price a liability could be settled for. However, given there is no active market or observable market transactions for many of the Company's financial instruments, the Company has made estimates of many of these fair values which are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimated values.

The estimated fair value of the instruments as of September 30, 2012 and December 31, 2011 are as follows (in thousands):



	Fair Value Measurements of
		September 30, 2012				December 31, 2011
	Level	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash, cash equivalents, restricted cash and federal funds sold	1	$	73,241	$	73,241	$	109,868	$	109,868
Available-for-sale securities	2 & 3	290,311		290,311		219,039		219,039
Held-to-maturity securities	2	14,843		16,447		16,143		17,471
Loans held for sale	2	5,070		5,070		5,561		5,561
Loans receivable, net	3	502,852		518,500		502,252		515,737
Accrued interest receivable	2	4,542		4,542		4,100		4,100
BOLI	1	9,387		9,387		9,127		9,127
Other assets	2	2,032		2,032		2,095		2,095
Financial liabilities:
Deposit liabilities	3	731,584		732,116		729,373		709,534
Borrowings	3	102,516		101,452		130,631		131,202
Accrued interest payable	2	2,124		2,124		1,676		1,676
Unexercised warrants	3	899		899		—		—
Other liabilities	2	385		385		635		635

Fair value is defined under ASC 820-10 as the price that would be received for an asset or paid to transfer a liability (an exit price) in the principal market for the asset or liability in an orderly transaction between market participants on the measurement date. Fair value estimates are based on quoted market prices, if available. If quoted market prices are not available, fair value estimates are based on quoted market prices of similar assets or liabilities, or the present value of expected future cash flows and other valuation techniques. These valuations are significantly affected by discount rates, cash flow assumptions, and risk and other assumptions used. Therefore, fair value estimates may not be substantiated by comparison to independent markets and are not intended to reflect the proceeds that may be realizable in an immediate settlement of the instruments.

Fair value is determined at one point in time and is not representative of future value. These amounts do not reflect the total value of a going concern organization. Management does not have the intention to dispose of a significant portion of its assets and liabilities and therefore, the unrealized gains or losses should not be interpreted as a forecast of future earnings and cash flows.

In support of these representations, ASC 820-10 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy is as follows:

Level 1 inputs — Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs — Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair values requires significant management judgment or estimation.

The methods and assumptions used to estimate the fair values of each class of financial instruments are as follows:

Cash, Cash Equivalents, Federal Funds and Certificates of Deposit

The carrying value of cash, cash equivalents, federal funds sold and certificates of deposit approximates fair value due to the relatively short-term nature of these instruments.

Securities

The fair values of securities, other than those categorized as level 3 described below, are based principally on market prices and dealer quotes. Certain fair values are estimated using pricing models or are based on comparisons to market prices of similar securities. Securities totaling $277.0 million classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtained fair value measurements from an independent pricing service and internally validated these measurements. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus, prepayment speeds, credit information and the bond’s terms and conditions, among other things.

The available for sale portfolio also includes $13.3 million in super senior or senior tranche collateralized mortgage obligations not backed by a government or other agency guarantee. These securities are valued using Level 3 inputs. These securities are collateralized by fixed rate prime or Alt A mortgages, are structured to provide credit support to the senior tranches, and are carefully analyzed and monitored by management. Because of disruptions in the current market for mortgage-backed securities and collateralized mortgage obligations, an active market did not exist for these securities at September 30, 2012. This is evidenced by a significant widening in the bid-ask spread for these types of securities and the limited volume of actual trades made. As a result, less reliance can be placed on easily observable market data, such as pricing on transactions involving similar types of securities, in determining their current fair value. As such, significant adjustments were required to determine the fair value at the September 30, 2012 measurement date.

In valuing these securities, the Company utilized the same independent pricing service as for its other available-for-sale securities and internally validated these measurements. In addition, it utilized FHLB indications, which are backed by significant experience in whole-loan collateralized mortgage obligation valuation and another market source to derive independent valuations, and used this data to evaluate and adjust the original values derived. In addition to the observable market-based input including dealer quotes, market spreads, live trading levels and execution data, both the pricing service and the FHLB pricing also employed a present-value income model that considered the nature and timing of the cash flows and the relative risk of receiving the anticipated cash flows as agreed. The discount rates used were based on a risk-free rate, adjusted by a risk premium for each security. In accordance with the requirements of ASC 820-10, the Company has determined that the risk-adjusted discount rates utilized appropriately reflect the Company’s best estimate of the assumptions that market participants would use in pricing the assets in a current transaction to sell the asset at the measurement date. Risks include nonperformance risk (that is, default risk and collateral value risk) and liquidity risk (that is, the compensation that a market participant receives for buying an asset that is difficult to sell under current market conditions). To the extent possible, the pricing services and the Company validated the results from these models with independently observable data.

BOLI

The fair value of BOLI is equal to the cash surrender value of the life insurance policies.

Other Assets

Other assets includes FHLB stock and an interest rate swap. The fair value of stock in the FHLB equals its carrying amount since such stock is only redeemable at its par value. The fair value of the interest rate swap is discussed below.

Loans Receivable and Loans Held For Sale

The fair value of performing mortgage loans, commercial real estate, construction, consumer and commercial loans is estimated by discounting the cash flows using interest rates that consider the interest rate risk inherent in the loans and current economic and lending conditions. See the discussion below for fair valuation of impaired loans. Non-accrual loans are assumed to be carried at their current fair value and therefore are not adjusted.

Deposits

The fair values for deposits subject to immediate withdrawal such as interest and non-interest bearing checking, savings and money market deposit accounts are discounted using market rates for replacement dollars and using Company and industry statistics for decay/maturity dates. The carrying amounts for variable-rate certificates of deposit approximate their fair value at the reporting date. Fair values for fixed-rate certificates of deposit 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 approximate their fair values due to the relatively short period of time between the origination of the instruments and their expected payment. The fair value of long-term FHLB Seattle advances and other long-term borrowings is estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements with similar remaining terms. The carrying amounts of variable rate Trust Preferred instruments approximate their fair values due to the relatively short period of time between repricing dates.

Accrued Interest

The carrying amounts of accrued interest payable and receivable approximate their fair value.

Interest Rate Swaps

The Company holds several interest rate swaps as a hedging strategy to help manage the Company's interest-rate-risk. Derivative contracts are valued by the counter party and are periodically validated by management. The counter-party determines the fair value of interest rate swaps using a discounted cash flow method based on current incremental rates for similar types of arrangements.

Unexercised Warrant Liability.

A liability for unexercised warrants was created as part of the Company's capital raise in January, 2012 (see Note 8--Stockholders' Equity). The liability is carried at fair value and adjustments are made periodically through non-interest income to record changes in the fair value. The fair value is measured using warrant valuation modeling techniques, which seek to estimate the market price that the unexercised options would bring if sold. Assumptions used in calculating the value include the volatility of the underlying stock, the risk-free interest rate, the expected term of the warrants, the market price of the underlying stock and the dividend yield on the stock.

The following tables present information about the Company’s assets measured at fair value on a recurring basis as of September 30, 2012, and December 31, 2011, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (in thousands).



	Assets and Liabilities Measured at Fair Value on a Recurring Basis
Description	Total			Level 1		Level 2		Level 3
Balance, 9/30/2012
Available-for-Sale Securities:
State and municipal bonds	$	53,917		$	—	$	53,917	$	—
Residential mortgage backed securities and SBA Pools	236,394			—		223,050		13,344
Other Assets — Derivative	(257		)	—		—		(257		)
Total Assets Measured at Fair Value	$	290,054		$	—	$	276,967	$	13,087
Other Liabilities — Derivatives	$	385		$	—	$	—	$	385
Unexercised Warrants	899			—		—		899
Total Liabilities Measured at Fair Value	$	1,284		$	—	$	—	$	1,284

Balance, 12/31/2011
Available-for-Sale Securities:
State and municipal bonds	37,135			—		37,135		—
Residential mortgage backed securities and SBA Pools	181,904			—		167,130		14,774
Other Assets — Derivative	(215		)	—		—		(215		)
Total Assets Measured at Fair Value	218,824			—		204,265		14,559
Other Liabilities — Derivatives	635			—		—		635
Total Liabilities Measured at Fair Value	635			—		—		635

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows (in thousands):



	Fair Value Measurements Using Significant Unobservable Inputs ( Level 3) Quarter to Date
	2012								2011
Description	Residential MBS			Derivatives (net)			Unexercised Warrants		Residential MBS			Derivatives (net)			Unexercised Warrants
July 1, Balance	$	13,501		$	(715	)	(850	)	$	29,366		$	(882	)	$	—
Total gains or losses (realized/unrealized):
Included in earnings	(34		)	73			(49	)	(69		)	(127		)	—
Included in other comprehensive income	606			—			—		(40		)	38			—
Principal Payments	(729		)	—			—		(540		)	—			—
Sales of Securities	—			—			—		(3,576		)	—			—
Transfers in and /or out of Level 3	—			—			—		—			—			—
September 30, Balance	13,344			(642		)	(899	)	25,141			(971		)	—



	Fair Value Measurements Using Significant Unobservable Inputs ( Level 3) Year to Date
	2012									2011
Description	Residential MBS			Derivatives (net)			Unexercised Warrants			Residential MBS			Derivatives (net)			Unexercised Warrants
January 1, Balance	$	14,774		$	(850	)	$	—		$	29,514		$	(930	)	$	—
Total gains or losses (realized/unrealized):							—
Included in earnings	(357		)	(338		)	108			(69		)	(90		)	—
Included in other comprehensive income	1,034			546			—			1,793			49			—
Principal Payments	(2,107		)	—			—			(2,521		)	—			—
Sales of Securities	—			—			—			(3,576		)	—			—
Unexercised warrants issued in capital raise	—			—			(1,007		)	—			—			—
Transfers in and /or out of Level 3	—			—			—			—			—			—
September 30, Balance	$	13,344		$	(642	)	$	(899	)	$	25,141		$	(971	)	$	—

The following tables present additional quantitative information about assets and liabilities measured at fair value on a recurring basis and for which the company has utilized Level 3 inputs to determine fair value, as of September 30, 2012:



	Valuation Techniques	Unobservable Input	Range of Inputs
Residential mortgage-backed securities	Discounted cash flow and consensus pricing	Prepayment	5.4 to 39.8 CPR (1)
		Default rates	0 to 10.55 CDR (2)
		Loss severities	0% to 131.78%
Interest Rate Derivatives	Discounted cash flow modeling and market indications	Cash flows of underlying instruments	Various payment mismatches based on characteristics of underlying loans
		Swap rates	0.50% to 1.00%
		LIBOR rates	0.25% to 0.75%
Unexercised Warrants	Warrant valuation models	Estimated underlying stock price volatility	90% to 100%
		Duration	2.0 to 2.5 years
		Risk-free rate	0.30% to 1.00%

(1) CPR: Constant prepayment rate
(2) CDR: Constant default rate

Intermountain may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis. The following table presents the carrying value for these financial assets as of dates indicated (in thousands):



Description	Total		Level 1		Level 2		Level 3
Balance, 9/30/2012
Loans(1)	$	17,594	$	—	$	—	$	17,594
OREO	5,636		—		—		5,636
Total Assets Measured at Fair Value	$	23,230	$	—	$	—	$	23,230
Balance, 12/31/2011
Loans(1)	$	25,885	$	—	$	—	$	25,885
OREO	6,650		—		—		6,650
Total Assets Measured at Fair Value	$	32,535	$	—	$	—	$	32,535

_____________________________


(1)	Represents impaired loans, net of allowance for loan loss, which are included in loans.

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the company has utilized Level 3 inputs to determine fair value at September 30, 2012:




	Valuation Techniques	Unobservable Input	Range of Inputs
Impaired Loans	Discounted cash flows and appraisal of collateral	Amount and timing of cash flows	No payment deferral to indefinite payment deferral
		Discount Rate	4% to 9%
		Appraisal adjustments	10% to 35%
		Liquidation Expenses	10% to 15%
OREO	Appraisal of collateral	Appraisal adjustments	10% to 35%
OREO	Appraisal of collateral	Liquidation Expenses	10% to 15%

Impaired Loans

Periodically, the Company records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for impaired loans when establishing the allowance for credit losses. Such amounts are generally based on either the estimated fair value of the cash flows to be received or the fair value of the underlying collateral supporting the loan less selling costs. Real estate collateral on these loans and the Company’s OREO is typically valued using appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace. Management reviews these valuations and makes additional valuation adjustments, as necessary, including subtracting estimated costs of liquidating the collateral or selling the OREO. If the value of the impaired loan is determined to be less than the recorded investment in the loans, the impairment is recognized and the carrying value of the loan is adjusted to fair value through the allowance for loan and lease losses. The carrying value of loans fully charged off is zero. The related nonrecurring fair value measurement adjustments have generally been classified as Level 3 because of the significant assumptions required estimating future cash flows on these loans, and the rapidly changing and uncertain collateral values underlying the loans. Volatility and the lack of relevant and current sales data in the Company’s market areas for various types of collateral create additional uncertainties and require the use of multiple sources and management judgment to make adjustments. Loans subject to nonrecurring fair value measurement were $17.6 million at September 30, 2012 all of which were classified as Level 3.

OREO

OREO represents real estate which the Company has taken control of in partial or full satisfaction of loans. At the time of foreclosure, OREO is recorded at the lower of the carrying amount of the loan or fair value less estimated costs to sell, which becomes the property’s new basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan and lease losses. After foreclosure, management periodically performs valuations such that the real estate is carried at the lower of its new cost basis or fair value, net of estimated costs to sell. Fair value adjustments on other real estate owned are recognized within net loss on real estate owned as a component of non-interest expense. Fair value is determined from external appraisals and other valuations using judgments and estimates of external professionals. Many of these inputs are not observable and, accordingly, these measurements are classified as Level 3. The Company’s OREO at September 30, 2012 totaled $5.6 million, all of which was classified as Level 3.