Hilltop Holdings Inc. - Quarter Report: 2014 June (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

 

For the quarterly period ended June 30, 2014

 

 

Commission File Number: 1-31987

 

Hilltop Holdings Inc.

(Exact name of registrant as specified in its charter)

 

 

 

(214) 855-2177

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o  No x

 

The number of shares of the registrant’s common stock outstanding at July 29, 2014 was 90,182,915.

 

 

Table of Contents

 

HILLTOP HOLDINGS INC.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2014

 

TABLE OF CONTENTS

 

PART I — FINANCIAL INFORMATION
Item 1.	Financial Statements.
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statements of Comprehensive Income (Loss)	5
	Consolidated Statements of Stockholders’ Equity	6
	Consolidated Statements of Cash Flows	7
	Notes to Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	50
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	81
Item 4.	Controls and Procedures	83
PART II — OTHER INFORMATION
Item 1.	Legal Proceedings	84
Item 1A.	Risk Factors	84
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	87
Item 6.	Exhibits	87

 

2

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

 

		June 30,			December 31,
		2014			2013
		(Unaudited)
Assets
Cash and due from banks		$	673,972		$	713,099
Federal funds sold and securities purchased under agreements to resell		14,813			32,924
Securities:
Trading, at fair value		61,663			58,846
Available for sale, at fair value (amortized cost of $1,205,912 and $1,256,862, respectively)		1,201,778			1,203,143
Held to maturity, at amortized cost (fair value of $65,631)		65,275			—
		1,328,716			1,261,989
Loans held for sale		1,410,873			1,089,039
Non-covered loans, net of unearned income		3,714,837			3,514,646
Allowance for non-covered loan losses		(36,431		)	(33,241		)
Non-covered loans, net		3,678,406			3,481,405
Covered loans, net of allowance of $4,115 and $1,061, respectively		840,898			1,005,308
Broker-dealer and clearing organization receivables		190,764			119,317
Insurance premiums receivable		27,957			25,597
Deferred policy acquisition costs		22,027			20,991
Premises and equipment, net		201,545			200,706
FDIC indemnification asset		175,114			188,291
Covered other real estate owned		142,174			142,833
Mortgage servicing rights		35,877			20,149
Other assets		336,199			279,745
Goodwill		251,808			251,808
Other intangible assets, net		65,305			70,921
Total assets		$	9,396,448		$	8,904,122
Liabilities and Stockholders’ Equity
Deposits:
Noninterest-bearing		$	1,829,072		$	1,773,749
Interest-bearing		4,326,238			4,949,169
Total deposits		6,155,310			6,722,918
Broker-dealer and clearing organization payables		227,891			129,678
Reserve for losses and loss adjustment expenses		35,146			27,468
Unearned insurance premiums		94,611			88,422
Short-term borrowings		1,187,193			342,087
Notes payable		55,584			56,327
Junior subordinated debentures		67,012			67,012
Other liabilities		176,539			158,288
Total liabilities		7,999,286			7,592,200
Commitments and contingencies (see Notes 11 and 12)
Stockholders’ equity:
Hilltop stockholders’ equity:
Preferred stock, $0.01 par value, 10,000,000 shares authorized; Series B, liquidation value per share of $1,000; 114,068 shares issued and outstanding		114,068			114,068
Common stock, $0.01 par value, 125,000,000 and 100,000,000 shares authorized; 90,180,699 and 90,175,688 shares issued and outstanding, respectively		902			902
Additional paid-in capital		1,387,883			1,388,641
Accumulated other comprehensive loss		(2,501		)	(34,863		)
Accumulated deficit		(103,910		)	(157,607		)
Total Hilltop stockholders’ equity		1,396,442			1,311,141
Noncontrolling interest		720			781
Total stockholders’ equity		1,397,162			1,311,922
Total liabilities and stockholders’ equity		$	9,396,448		$	8,904,122

 

See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2014			2013			2014			2013
Interest income:
Loans, including fees		$	92,204		$	65,213		$	171,948		$	130,099
Securities:
Taxable		7,618			6,480			15,206			12,392
Tax-exempt		1,187			1,189			2,429			2,536
Federal funds sold and securities purchased under agreements to resell		14			35			33			56
Interest-bearing deposits with banks		317			242			912			575
Other		3,068			3,009			5,708			5,114
Total interest income		104,408			76,168			196,236			150,772
Interest expense:
Deposits		3,096			3,406			6,855			6,856
Short-term borrowings		539			591			934			1,104
Notes payable		632			2,308			1,280			4,630
Junior subordinated debentures		587			612			1,171			1,220
Other		1,108			826			2,129			1,276
Total interest expense		5,962			7,743			12,369			15,086
Net interest income		98,446			68,425			183,867			135,686
Provision for loan losses		5,533			11,289			8,775			24,294
Net interest income after provision for loan losses		92,913			57,136			175,092			111,392
Noninterest income:
Net gains from sale of loans and other mortgage production income		106,054			142,531			185,165			270,127
Mortgage loan origination fees		16,983			22,695			29,327			41,588
Net insurance premiums earned		40,777			38,590			81,096			76,063
Investment and securities advisory fees and commissions		22,264			25,964			43,599			47,973
Other		17,203			9,453			34,194			16,760
Total noninterest income		203,281			239,233			373,381			452,511
Noninterest expense:
Employees’ compensation and benefits		124,445			132,715			230,874			248,905
Loss and loss adjustment expenses		35,275			48,160			53,612			69,345
Policy acquisition and other underwriting expenses		11,652			11,627			23,339			22,430
Occupancy and equipment, net		25,762			20,154			52,100			39,566
Other		54,078			47,744			103,916			95,145
Total noninterest expense		251,212			260,400			463,841			475,391
Income before income taxes		44,982			35,969			84,632			88,512
Income tax expense		16,294			13,309			30,648			32,479
Net income		28,688			22,660			53,984			56,033
Less: Net income attributable to noncontrolling interest		177			568			287			868
Income attributable to Hilltop		28,511			22,092			53,697			55,165
Dividends on preferred stock		1,426			1,149			2,852			1,852
Income applicable to Hilltop common stockholders		$	27,085		$	20,943		$	50,845		$	53,313
Earnings per common share:
Basic		$	0.30		$	0.25		$	0.56		$	0.64
Diluted		$	0.30		$	0.24		$	0.56		$	0.61
Weighted average share information:
Basic		89,709			83,490			89,708			83,489
Diluted		90,569			90,294			90,576			90,125

 

 See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2014			2013			2014			2013
Net income		$	28,688		$	22,660		$	53,984		$	56,033
Other comprehensive income (loss):
Unrealized gains (losses) on securities available for sale, net of tax of $7,638, $(15,249), $17,221 and $(14,776)		13,553			(28,320		)	32,362			(27,441		)
Comprehensive income (loss)		42,241			(5,660		)	86,346			28,592
Less: comprehensive income attributable to noncontrolling interest		177			568			287			868
Comprehensive income (loss) applicable to Hilltop		$	42,064		$	(6,228	)	$	86,059		$	27,724

 

See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

(Unaudited)

 

															Accumulated						Total
												Additional			Other						Hilltop						Total
		Preferred Stock					Common Stock					Paid-in			Comprehensive			Accumulated			Stockholders’			Noncontrolling			Stockholders’
		Shares		Amount			Shares		Amount			Capital			Income (Loss)			Deficit			Equity			Interest			Equity
Balance, December 31, 2012		114		$	114,068		83,487		$	835		$	1,304,448		$	8,094		$	(282,949	)	$	1,144,496		$	2,054		$	1,146,550
Net income		—		—			—		—			—			—			55,165			55,165			868			56,033
Other comprehensive loss		—		—			—		—			—			(27,441		)	—			(27,441		)	—			(27,441		)
Stock-based compensation expense		—		—			—		—			480			—			—			480			—			480
Common stock issued to board members		—		—			4		—			47			—			—			47			—			47
Issuance of restricted common stock		—		—			465		5			(5		)	—			—			—			—			—
Dividends on preferred stock		—		—			—		—			(1,852		)	—			—			(1,852		)	—			(1,852		)
Cash distributions to noncontrolling interest		—		—			—		—			—			—			—			—			(2,017		)	(2,017		)
Balance, June 30, 2013		114		$	114,068		83,956		$	840		$	1,303,118		$	(19,347	)	$	(227,784	)	$	1,170,895		$	905		$	1,171,800
Balance, December 31, 2013		114		$	114,068		90,176		$	902		$	1,388,641		$	(34,863	)	$	(157,607	)	$	1,311,141		$	781		$	1,311,922
Net income		—		—			—		—			—			—			53,697			53,697			287			53,984
Other comprehensive income		—		—			—		—			—			32,362			—			32,362			—			32,362
Stock-based compensation expense		—		—			—		—			1,979			—			—			1,979			—			1,979
Common stock issued to board members		—		—			5		—			115			—			—			115			—			115
Dividends on preferred stock		—		—			—		—			(2,852		)	—			—			(2,852		)	—			(2,852		)
Cash distributions to noncontrolling interest		—		—			—		—			—			—			—			—			(348		)	(348		)
Balance, June 30, 2014		114		$	114,068		90,181		$	902		$	1,387,883		$	(2,501	)	$	(103,910	)	$	1,396,442		$	720		$	1,397,162

 

See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

		Six Months Ended June 30,
		2014			2013
Operating Activities
Net income		$	53,984		$	56,033
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for loan losses		8,775			24,294
Depreciation, amortization and accretion, net		(48,612		)	(18,032		)
Deferred income taxes		4,842			(11,528		)
Other, net		2,191			533
Net change in securities purchased under resale agreements		—			(3,237		)
Net change in trading securities		(2,817		)	57,256
Net change in broker-dealer and clearing organization receivables		(146,643		)	(76,430		)
Net change in other assets		(28,818		)	34,972
Net change in broker-dealer and clearing organization payables		177,748			17,281
Net change in loss and loss adjustment expense reserve		7,678			8,446
Net change in unearned insurance premiums		6,189			7,813
Net change in other liabilities		4,645			(37,247		)
Net gains from sale of loans		(185,165		)	(270,127		)
Loans originated for sale		(4,927,983		)	(6,545,177		)
Proceeds from loans sold		4,782,239			6,769,795
Net cash provided by (used in) operating activities		(291,747		)	14,645
Investing Activities
Proceeds from maturities and principal reductions of securities held to maturity		911			—
Proceeds from sales, maturities and principal reductions of securities available for sale		97,867			96,069
Purchases of securities held to maturity		(66,207		)	—
Purchases of securities available for sale		(47,557		)	(223,570		)
Net change in loans		68,552			(51,027		)
Purchases of premises and equipment and other assets		(19,815		)	(11,417		)
Proceeds from sales of premises and equipment and other real estate owned		38,281			4,859
Net cash paid for Federal Home Loan Bank and Federal Reserve Bank stock		(31,440		)	(21,219		)
Net cash provided by (used in) investing activities		40,592			(206,305		)
Financing Activities
Net change in deposits		(647,143		)	(179,826		)
Net change in short-term borrowings		845,106			275,554
Proceeds from notes payable		1,000			—
Payments on notes payable		(1,743		)	(1,601		)
Dividends paid on preferred stock		(2,768		)	(703		)
Net cash distributed to noncontrolling interest		(348		)	(2,017		)
Other, net		(187		)	(154		)
Net cash provided by financing activities		193,917			91,253
Net change in cash and cash equivalents		(57,238		)	(100,407		)
Cash and cash equivalents, beginning of period		746,023			726,460
Cash and cash equivalents, end of period		$	688,785		$	626,053
Supplemental Disclosures of Cash Flow Information
Cash paid for interest		$	13,046		$	14,889
Cash paid for income taxes, net of refunds		$	5,582		$	40,949
Supplemental Schedule of Non-Cash Activities
Conversion of loans to other real estate owned		$	34,391		$	1,718

 

See accompanying notes.

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Unaudited)

 

1. Summary of Significant Accounting and Reporting Policies

 

Nature of Operations

 

Hilltop Holdings Inc. (“Hilltop” and, collectively with its subsidiaries, the “Company”) is a financial holding company registered under the Bank Holding Company Act of 1956, as amended by the Gramm-Leach-Bliley Act of 1999. On November 30, 2012, Hilltop acquired PlainsCapital Corporation pursuant to a plan of merger whereby PlainsCapital Corporation merged with and into a wholly owned subsidiary of Hilltop (the “PlainsCapital Merger”), which continued as the surviving entity under the name “PlainsCapital Corporation” (“PlainsCapital”).

 

The Company has two primary operating business units, PlainsCapital and National Lloyds Corporation (“NLC”). PlainsCapital is a financial holding company, headquartered in Dallas, Texas, that provides, through its subsidiaries, an array of financial products and services. In addition to traditional banking services, PlainsCapital provides residential mortgage lending, investment banking, public finance advisory, wealth and investment management, treasury management, capital equipment leasing, fixed income sales, asset management, and correspondent clearing services. NLC is a property and casualty insurance holding company that provides, through its subsidiaries, fire and homeowners insurance to low value dwellings and manufactured homes primarily in Texas and other areas of the southern United States.

 

On September 13, 2013 (the “Bank Closing Date”), PlainsCapital Bank (the “Bank”) assumed substantially all of the liabilities, including all of the deposits, and acquired substantially all of the assets of Edinburg, Texas-based First National Bank (“FNB”) from the Federal Deposit Insurance Corporation (the “FDIC”), as receiver, and reopened former FNB branches acquired from the FDIC under the “PlainsCapital Bank” name (the “FNB Transaction”). Pursuant to the Purchase and Assumption Agreement (the “P&A Agreement”), the Bank and the FDIC entered into loss-share agreements whereby the FDIC agreed to share in the losses of certain covered loans and covered other real estate owned (“OREO”) that the Bank acquired, as further described in Note 2 to the consolidated financial statements. The fair value of the assets acquired was $2.2 billion, including $1.1 billion in covered loans, $286.2 million in securities, $135.2 million in covered OREO and $42.9 million in non-covered loans. The Bank also assumed $2.2 billion in liabilities, consisting primarily of deposits. The acquisition of FNB’s expansive branch network allowed the Bank to increase its presence in Texas to include the Rio Grande Valley, Houston, Corpus Christi, Laredo and El Paso markets, among others.

 

On March 31, 2014, the Company entered into a definitive merger agreement with SWS Group, Inc. (“SWS”) providing for the merger of SWS with and into Peruna LLC, a wholly owned subsidiary of Hilltop formed for the purpose of facilitating this transaction. SWS stockholders will receive per share consideration of 0.2496 shares of Hilltop common stock and $1.94 of cash, equating to $7.25 per share based on Hilltop’s closing price on June 30, 2014. The value of the merger consideration will fluctuate with the market price of Hilltop common stock. The Company intends to fund the cash portion of the consideration through available cash. The merger is subject to customary closing conditions, including regulatory approvals and approval of the stockholders of SWS, and is expected to be completed prior to the end of 2014.

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”), and in conformity with the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of management, these financial statements contain all adjustments necessary for a fair statement of the results of the interim periods presented. Accordingly, the financial statements do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. Results for interim periods are not necessarily indicative of results to be expected for a full year or any future period.

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates regarding the allowance for loan losses, the fair values of financial instruments, the amounts receivable under the loss-share agreements with the FDIC (“FDIC Indemnification Asset”), reserves for losses and loss adjustment expenses, the mortgage loan indemnification liability, and the potential impairment of assets are particularly subject to change. The Company has applied its critical accounting policies and estimation methods consistently in all periods presented in these consolidated financial statements.

 

Certain reclassifications have been made to the prior period consolidated financial statements to conform with the current period presentation.

 

Hilltop owns 100% of the outstanding stock of PlainsCapital. PlainsCapital owns 100% of the outstanding stock of the Bank and 100% of the membership interest in PlainsCapital Equity, LLC. The Bank owns 100% of the outstanding stock of PrimeLending, a PlainsCapital Company (“PrimeLending”), PCB-ARC, Inc. and RGV-ARC, Inc. The Bank has a 100% membership interest in First Southwest Holdings, LLC (“First Southwest”) and PlainsCapital Securities, LLC.

 

Hilltop also owns 100% of NLC, which operates through its wholly owned subsidiaries, National Lloyds Insurance Company (“NLIC”) and American Summit Insurance Company (“ASIC”).

 

PrimeLending owns a 100% membership interest in PrimeLending Ventures Management, LLC, the controlling and sole managing member of PrimeLending Ventures, LLC (“Ventures”).

 

The principal subsidiaries of First Southwest are First Southwest Company (“FSC”), a broker-dealer registered with the SEC and the Financial Industry Regulatory Authority and a member of the New York Stock Exchange, and First Southwest Asset Management, Inc., a registered investment advisor under the Investment Advisors Act of 1940.

 

The consolidated financial statements include the accounts of the above-named entities. All significant intercompany transactions and balances have been eliminated. Noncontrolling interests have been recorded for minority ownership in entities that are not wholly owned and are presented in compliance with the provisions of Noncontrolling Interest in Subsidiary Subsections of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”).

 

PlainsCapital also owns 100% of the outstanding common securities of PCC Statutory Trusts I, II, III and IV (the “Trusts”), which are not included in the consolidated financial statements under the requirements of the Variable Interest Entities Subsections of the ASC, because the primary beneficiaries of the Trusts are not within the consolidated group.

 

2. Acquisitions

 

FNB Transaction

 

On the Bank Closing Date, the Bank assumed substantially all of the liabilities, including all of the deposits, and acquired substantially all of the assets of FNB from the FDIC in an FDIC-assisted transaction. As part of the P&A Agreement, the Bank and the FDIC entered into loss-share agreements covering future losses incurred on certain acquired loans and OREO. The Company refers to acquired commercial and single family residential loan portfolios and OREO that are subject to the loss-share agreements as “covered loans” and “covered OREO”, respectively, and these assets are presented as separate line items in the Company’s consolidated balance sheet. Collectively, covered loans and covered OREO are referred to as “covered assets”.

 

In accordance with the loss-share agreements, the Bank may be required to make a “true-up” payment to the FDIC approximately ten years following the Bank Closing Date if the FDIC’s initial estimate of losses on covered assets is greater than the actual realized losses. The “true-up” payment is calculated using a defined formula set forth in the P&A Agreement.

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

The FNB Transaction was accounted for using the purchase method of accounting and, accordingly, purchased assets, including identifiable intangible assets and assumed liabilities, were recorded at their respective fair values as of the Bank Closing Date using significant estimates and assumptions to value certain identifiable assets acquired and liabilities assumed. The amounts are subject to adjustments based upon final settlement with the FDIC. The terms of the P&A Agreement provide for the FDIC to indemnify the Bank against claims with respect to liabilities and assets of FNB or any of its affiliates not assumed or otherwise purchased by the Bank and with respect to certain other claims by third parties.

 

Pro Forma Results of Operations

 

The operations acquired in the FNB Transaction are included in the Company’s operating results beginning September 14, 2013. The purchase of assets and assumption of certain liabilities of FNB from the FDIC, as receiver, was sufficiently significant to require disclosure of historical financial statements and related pro forma financial disclosure. Due to the nature and magnitude of the FNB Transaction, coupled with the federal assistance and protection resulting from the FDIC loss-share agreements, historical financial information of FNB is not relevant to future operations. The Company has omitted certain historical financial information and the related pro forma financial information of FNB pursuant to the guidance provided in Staff Accounting Bulletin Topic 1.K, Financial Statements of Acquired Troubled Financial Institutions (“SAB 1:K”), and a request for relief granted by the SEC. SAB 1:K provides relief from the requirements of Rule 3-05 of Regulation S-X in certain instances, such as the FNB Transaction, where a registrant engages in an acquisition of a significant amount of assets of a troubled financial institution for which audited financial statements are not reasonably available and in which federal assistance is so persuasive as to substantially reduce the relevance of such information to an assessment of future operations.

 

3. Fair Value Measurements

 

Fair Value Measurements and Disclosures

 

The Company determines fair values in compliance with The Fair Value Measurements and Disclosures Topic of the ASC (the “Fair Value Topic”). The Fair Value Topic defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. The Fair Value Topic defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The Fair Value Topic assumes that transactions upon which fair value measurements are based occur in the principal market for the asset or liability being measured. Further, fair value measurements made under the Fair Value Topic exclude transaction costs and are not the result of forced transactions.

 

The Fair Value Topic creates a fair value hierarchy that classifies fair value measurements based upon the inputs used in valuing the assets or liabilities that are the subject of fair value measurements. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs, as indicated below.

 

·                  Level 1 Inputs: Unadjusted quoted prices in active markets for identical assets or liabilities that the Company can access at the measurement date.

 

·                  Level 2 Inputs: Observable inputs other than Level 1 prices. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves, prepayment speeds, default rates, credit risks, loss severities, etc.), and inputs that are derived from or corroborated by market data, among others.

 

·                  Level 3 Inputs: Unobservable inputs that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities. Level 3 inputs include pricing models and discounted cash flow techniques, among others.

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

Fair Value Option

 

The Company has elected to measure substantially all of PrimeLending’s mortgage loans held for sale and retained mortgage servicing rights (“MSR”) at fair value, under the provisions of the Fair Value Option. The Company elected to apply the provisions of the Fair Value Option to these items so that it would have the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The Company determines the fair value of the financial instruments accounted for under the provisions of the Fair Value Option in compliance with the provisions of the Fair Value Topic of the ASC discussed above.

 

At June 30, 2014, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.41 billion, and the unpaid principal balance of those loans was $1.35 billion. At December 31, 2013, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.09 billion, and the unpaid principal balance of those loans was $1.07 billion. The interest component of fair value is reported as interest income on loans in the accompanying consolidated statements of operations.

 

The Company holds a number of financial instruments that are measured at fair value on a recurring basis, either by the application of the Fair Value Option or other authoritative pronouncements. The fair values of those instruments are determined primarily using Level 2 inputs. Those inputs include quotes from mortgage loan investors and derivatives dealers and data from independent pricing services.

 

The following tables present information regarding financial assets and liabilities measured at fair value on a recurring basis (in thousands).

 

		Level 1			Level 2			Level 3			Total
		Inputs			Inputs			Inputs			Fair Value
June 30, 2014
Trading securities		$	35		$	61,628		$	—		$	61,663
Available for sale securities		24,653			1,113,306			63,819			1,201,778
Loans held for sale		—			1,400,464			10,409			1,410,873
Derivative assets		—			35,454			—			35,454
Mortgage servicing rights asset		—			—			35,877			35,877
Trading liabilities		—			48			—			48
Derivative liabilities		—			13,847			6,300			20,147

 

		Level 1			Level 2			Level 3			Total
		Inputs			Inputs			Inputs			Fair Value
December 31, 2013
Trading securities		$	33		$	58,813		$	—		$	58,846
Available for sale securities		22,079			1,121,011			60,053			1,203,143
Loans held for sale		—			1,061,310			27,729			1,089,039
Derivative assets		—			23,564			—			23,564
Mortgage servicing rights asset		—			—			20,149			20,149
Trading liabilities		—			46			—			46
Derivative liabilities		—			139			5,600			5,739

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

The following tables include a roll forward for those financial instruments measured at fair value using Level 3 inputs (in thousands).

 

											Total Gains or Losses
											(Realized or Unrealized)
		Balance at												Included in Other
		Beginning of			Purchases/			Sales/			Included in			Comprehensive			Balance at
		Period			Additions			Reductions			Net Income			Income (Loss)			End of Period
Three months ended June 30, 2014
Available for sale securities		$	64,098		$	—		$	—		$	616		$	(895	)	$	63,819
Loans held for sale		26,826			5,522			(24,009		)	2,070			—			10,409
Mortgage servicing rights asset		29,939			7,376			—			(1,438		)	—			35,877
Derivative liabilities		(5,950		)	—			—			(350		)	—			(6,300		)
Total		$	114,913		$	12,898		$	(24,009	)	$	898		$	(895	)	$	103,805
Six months ended June 30, 2014
Available for sale securities		$	60,053		$	—		$	—		$	1,209		$	2,557		$	63,819
Loans held for sale		27,729			10,422			(29,603		)	1,861			—			10,409
Mortgage servicing rights asset		20,149			14,808			—			920			—			35,877
Derivative liabilities		(5,600		)	—			—			(700		)	—			(6,300		)
Total		$	102,331		$	25,230		$	(29,603	)	$	3,290		$	2,557		$	103,805
Three months ended June 30, 2013
Available for sale securities		$	58,801		$	—		$	—		$	531		$	(3,822	)	$	55,510
Mortgage servicing rights asset		4,430			2,180			—			501			—			7,111
Derivative liabilities		(4,714		)	—			—			(225		)	—			(4,939		)
Total		$	58,517		$	2,180		$	—		$	807		$	(3,822	)	$	57,682
Six months ended June 30, 2013
Available for sale securities		$	56,277		$	—		$	—		$	1,043		$	(1,810	)	$	55,510
Mortgage servicing rights asset		2,080			4,305			—			726			—			7,111
Derivative liabilities		(4,490		)	—			—			(449		)	—			(4,939		)
Total		$	53,867		$	4,305		$	—		$	1,320		$	(1,810	)	$	57,682

 

All net realized and unrealized gains (losses) in the tables above are reflected in the accompanying consolidated financial statements. The unrealized gains (losses) relate to financial instruments still held at June 30, 2014. The available for sale securities noted in the table above reflect Hilltop’s note receivable and warrant to purchase common stock of SWS as discussed in Note 4 to the consolidated financial statements.

 

For Level 3 financial instruments measured at fair value on a recurring basis at June 30, 2014, the significant unobservable inputs used in the fair value measurements were as follows.

 

						Weighted
Financial instrument		Valuation Technique		Unobservable Input		Average / Range
Available for sale securities - note receivable		Discounted cash flow		Discount rate		8.3%
Available for sale securities - warrant		Binomial model		SWS common stock price volatility		24.0%
Loans held for sale		Discounted cash flow /		Projected price		86 - 90%
		Market comparable
Mortgage servicing rights asset		Discounted cash flow		Constant prepayment rate		10.32%
				Discount rate		11.11%
Derivative liabilities		Discounted cash flow		Discount rate		14 - 28%
				Time to receive full payment of cash flows		10.75 - 14.0 years

 

Hilltop’s note receivable is valued using a cash flow model that estimates yield based on comparable securities in the market. The interest rate used to discount cash flows is the most significant unobservable input. An increase or decrease in the discount rate would result in a corresponding decrease or increase, respectively, in the fair value measurement of the note receivable.

 

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