Hilltop Holdings Inc. - Quarter Report: 2015 March (Form 10-Q)

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2015

 

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

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 May 6, 2015 was 100,289,492.

 

 

Table of Contents

 

HILLTOP HOLDINGS INC.

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2015

 

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	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	54
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	86
Item 4.	Controls and Procedures	88
PART II — OTHER INFORMATION
Item 1.	Legal Proceedings	88
Item 1A.	Risk Factors	88
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	90
Item 6.	Exhibits	90

 

2

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

(Unaudited)

 

		March 31,			December 31,
		2015			2014
Assets
Cash and due from banks		$	694,108		$	782,473
Federal funds sold		14,425			30,602
Securities purchased under agreements to resell		67,227			—
Assets segregated for regulatory purposes		278,280			76,013
Securities:
Trading, at fair value		320,153			65,717
Available for sale, at fair value (amortized cost of $850,430 and $924,755, respectively)		859,212			925,535
Held to maturity, at amortized cost (fair value of $186,032 and $118,345, respectively)		183,792			118,209
		1,363,157			1,109,461
Loans held for sale		1,215,308			1,309,693
Non-covered loans, net of unearned income		4,834,687			3,920,476
Allowance for non-covered loan losses		(39,365		)	(37,041		)
Non-covered loans, net		4,795,322			3,883,435
Covered loans, net of allowance of $1,388 and $4,611, respectively		550,626			638,029
Broker-dealer and clearing organization receivables		2,222,517			167,884
Premises and equipment, net		215,684			206,991
FDIC indemnification asset		107,567			130,437
Covered other real estate owned		137,703			136,945
Other assets		581,210			458,862
Goodwill		251,808			251,808
Other intangible assets, net		67,952			59,783
Total assets		$	12,562,894		$	9,242,416
Liabilities and Stockholders’ Equity
Deposits:
Noninterest-bearing		$	2,259,790		$	2,076,385
Interest-bearing		4,869,487			4,293,507
Total deposits		7,129,277			6,369,892
Broker-dealer and clearing organization payables		1,951,040			179,042
Short-term borrowings		999,476			762,696
Securities sold, not yet purchased, at fair value		139,481			48
Notes payable		108,682			56,684
Junior subordinated debentures		67,012			67,012
Other liabilities		385,607			345,803
Total liabilities		10,780,575			7,781,177
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 shares authorized; 100,286,330 and 90,181,888 shares issued and outstanding, respectively		1,003			902
Additional paid-in capital		1,592,585			1,390,788
Accumulated other comprehensive income		5,750			651
Retained earnings (accumulated deficit)		67,445			(45,957		)
Deferred compensation employee stock trust, net		1,189			—
Employee stock trust (29,932 shares, at cost)		(597		)	—
Total Hilltop stockholders’ equity		1,781,443			1,460,452
Noncontrolling interests		876			787
Total stockholders’ equity		1,782,319			1,461,239
Total liabilities and stockholders’ equity		$	12,562,894		$	9,242,416

 

See accompanying notes.

 

3

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CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 (Unaudited)

 

		Three Months Ended March 31,
		2015			2014
Interest income:
Loans, including fees		$	87,388		$	79,744
Securities borrowed		10,018			1,464
Securities:
Taxable		7,049			7,588
Tax-exempt		1,741			1,242
Other		1,473			1,790
Total interest income		107,669			91,828
Interest expense:
Deposits		4,315			3,759
Securities loaned		7,506			838
Short-term borrowings		1,024			397
Notes payable		669			648
Junior subordinated debentures		585			584
Other		178			181
Total interest expense		14,277			6,407
Net interest income		93,392			85,421
Provision for loan losses		2,687			3,242
Net interest income after provision for loan losses		90,705			82,179
Noninterest income:
Net realized gains on securities		4,403			—
Net gains from sale of loans and other mortgage production income		120,545			79,111
Mortgage loan origination fees		14,589			12,344
Net insurance premiums earned		39,567			40,319
Securities commissions and fees		43,051			6,998
Investment banking and advisory fees		24,922			14,337
Bargain purchase gain		82,816			—
Other		24,479			16,991
Total noninterest income		354,372			170,100
Noninterest expense:
Employees’ compensation and benefits		182,573			106,429
Loss and loss adjustment expenses		18,860			18,337
Policy acquisition and other underwriting expenses		11,674			11,687
Occupancy and equipment, net		29,185			26,338
Other		72,184			49,838
Total noninterest expense		314,476			212,629
Income before income taxes		130,601			39,650
Income tax expense		15,420			14,354
Net income		115,181			25,296
Less: Net income attributable to noncontrolling interest		353			110
Income attributable to Hilltop		114,828			25,186
Dividends on preferred stock		1,426			1,426
Income applicable to Hilltop common stockholders		$	113,402		$	23,760
Earnings per common share:
Basic		$	1.13		$	0.26
Diluted		$	1.13		$	0.26
Weighted average share information:
Basic		99,741			89,707
Diluted		100,627			90,585

 

See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(Unaudited)

 

		Three Months Ended March 31,
		2015			2014
Net income		$	115,181		$	25,296
Other comprehensive income:
Net unrealized gains on securities available for sale and other, net of tax of $4,454 and $9,583, respectively		7,913			18,809
Reclassification adjustment for gains included in net income, net of tax of $(1,589)		(2,814		)	—
Comprehensive income		120,280			44,105
Less: comprehensive income attributable to noncontrolling interest		353			110
Comprehensive income applicable to Hilltop		$	119,927		$	43,995

 

See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

(Unaudited)

 

															Accumulated			Retained			Deferred								Total
												Additional			Other			Earnings			Compensation			Employee					Hilltop						Total
		Preferred Stock					Common Stock					Paid-in			Comprehensive			(Accumulated			Employee Stock			Stock Trust					Stockholders’			Noncontrolling			Stockholders’
		Shares		Amount			Shares		Amount			Capital			Income (Loss)			Deficit)			Trust, Net			Shares		Amount			Equity			Interest			Equity
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		—		—			—		—			—			—			25,186			—			—		—			25,186			110			25,296
Other comprehensive income		—		—			—		—			—			18,809			—			—			—		—			18,809			—			18,809
Stock-based compensation expense		—		—			—		—			735			—			—			—			—		—			735			—			735
Common stock issued to board members		—		—			2		—			52			—			—			—			—		—			52			—			52
Dividends on preferred stock		—		—			—		—			(1,426		)	—			—			—			—		—			(1,426		)	—			(1,426		)
Cash distributions to noncontrolling interest		—		—			—		—			—			—			—			—			—		—			—			(175		)	(175		)
Balance, March 31, 2014		114		$	114,068		90,178		$	902		$	1,388,002		$	(16,054	)	$	(132,421	)	$	—		—		$	—		$	1,354,497		$	716		$	1,355,213
Balance, December 31, 2014		114		$	114,068		90,182		$	902		$	1,390,788		$	651		$	(45,957	)	$	—		—		$	—		$	1,460,452		$	787		$	1,461,239
Net income		—		—			—		—			—			—			114,828			—			—		—			114,828			353			115,181
Other comprehensive income		—		—			—		—			—			5,099			—			—			—		—			5,099			—			5,099
Issuance of common stock		—		—			10,102		101			199,932			—			—			—			—		—			200,033			—			200,033
Stock-based compensation expense		—		—			—		—			1,814			—			—			—			—		—			1,814			—			1,814
Common stock issued to board members		—		—			2		—			51			—			—			—			—		—			51			—			51
Dividends on preferred stock		—		—			—		—			—			—			(1,426		)	—			—		—			(1,426		)	—			(1,426		)
Deferred compensation plan		—		—			—		—			—			—			—			1,189			30		(597		)	592			—			592
Cash distributions to noncontrolling interest		—		—			—		—			—			—			—			—			—		—			—			(264		)	(264		)
Balance, March 31, 2015		114		$	114,068		100,286		$	1,003		$	1,592,585		$	5,750		$	67,445		$	1,189		30		$	(597	)	$	1,781,443		$	876		$	1,782,319

 

See accompanying notes.

 

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

		Three Months Ended March 31,
		2015			2014
Operating Activities
Net income		$	115,181		$	25,296
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for loan losses		2,687			3,242
Depreciation, amortization and accretion, net		(14,486		)	(20,615		)
Net realized gains on securities		(4,403		)	—
Bargain purchase gain		(82,816		)	—
Deferred income taxes		(2,545		)	4,878
Other, net		(3,813		)	1,435
Net change in securities purchased under agreements to resell		(22,486		)	—
Net change in assets segregated for regulatory purposes		(20,657		)	—
Net change in trading securities		11,632			5,496
Net change in broker-dealer and clearing organization receivables		(1,062,969		)	(88,613		)
Net change in FDIC Indemnification Asset		23,376			912
Net change in other assets		(34,554		)	(458		)
Net change in broker-dealer and clearing organization payables		1,039,786			62,842
Net change in other liabilities		(52,528		)	(34,759		)
Net gains from sales of loans		(120,545		)	(79,111		)
Loans originated for sale		(2,904,331		)	(1,954,133		)
Proceeds from loans sold		3,094,705			2,227,917
Net cash provided by (used in) operating activities		(38,766		)	154,329
Investing Activities
Proceeds from maturities and principal reductions of securities held to maturity		6,329			351
Proceeds from sales, maturities and principal reductions of securities available for sale		449,892			31,845
Purchases of securities held to maturity		—			(31,334		)
Purchases of securities available for sale		(2,623		)	(46,024		)
Net change in loans		267,275			(256		)
Purchases of premises and equipment and other assets		(5,565		)	(8,710		)
Proceeds from sales of premises and equipment and other real estate owned		31,818			14,713
Net cash received for Federal Home Loan Bank and Federal Reserve Bank stock		4,044			—
Net cash from acquisition		41,097			—
Net cash provided by (used in) investing activities		792,267			(39,415		)
Financing Activities
Net change in deposits		(905,890		)	(90,374		)
Net change in short-term borrowings		72,540			149,319
Proceeds from notes payable		1,000			—
Payments on notes payable		(23,904		)	(862		)
Dividends paid on preferred stock		(1,426		)	(1,342		)
Net cash distributed to noncontrolling interest		(264		)	(175		)
Other, net		(99		)	(93		)
Net cash provided by (used in) financing activities		(858,043		)	56,473
Net change in cash and cash equivalents		(104,542		)	171,387
Cash and cash equivalents, beginning of period		813,075			746,023
Cash and cash equivalents, end of period		$	708,533		$	917,410
Supplemental Disclosures of Cash Flow Information
Cash paid for interest		$	14,325		$	6,934
Cash paid for income taxes, net of refunds		$	45,981		$	(1,845	)
Supplemental Schedule of Non-Cash Activities
Conversion of loans to other real estate owned		$	26,211		$	25,588
Common stock issued in acquisition		$	200,626		$	—

 

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. The Company’s primary line of business is to provide business and consumer banking services from offices located throughout Texas through PlainsCapital Bank (the “Bank”). In addition, the Company provides an array of financial products and services through its broker-dealer, mortgage origination and insurance subsidiaries.

 

The Company provides its products and services through three primary operating subsidiaries, PlainsCapital Corporation (“PlainsCapital”), Hilltop Securities Holdings LLC (“Hilltop Securities”) and National Lloyds Corporation (“NLC”). PlainsCapital is a financial holding company, headquartered in Dallas, Texas, that provides, through its subsidiaries, traditional banking services, wealth and investment management and treasury management primarily in Texas and residential mortgage lending throughout the United States. Hilltop Securities is a holding company, headquartered in Dallas, Texas, that provides, through its subsidiaries, investment banking and other related financial services, including municipal advisory, sales, trading and underwriting of taxable and tax-exempt fixed income securities, equity trading, clearing, securities lending, structured finance and retail brokerage services throughout the United States. NLC is a property and casualty insurance holding company, headquartered in Waco, Texas, 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 January 1, 2015, Hilltop completed its acquisition of SWS Group, Inc. (“SWS”) in a stock and cash transaction, whereby SWS merged with and into Hilltop Securities, a wholly owned subsidiary of Hilltop initially formed for the purpose of facilitating this transaction (the “SWS Merger”). SWS’s broker-dealer subsidiaries, Southwest Securities (“Southwest Securities”) and SWS Financial Services, Inc. (“SWS Financial”), became subsidiaries of Hilltop Securities. Immediately following the SWS Merger, SWS’s banking subsidiary, Southwest Securities, FSB (“SWS FSB”), was merged into the Bank, an indirect wholly owned subsidiary of Hilltop. As a result of the SWS Merger, each outstanding share of SWS common stock was converted into the right to receive 0.2496 shares of Hilltop common stock and $1.94 in cash, equating to $6.92 per share based on Hilltop’s closing price on December 31, 2014 and resulting in an aggregate purchase price of $349.1 million, consisting of 10.1 million shares of common stock, $78.2 million in cash and $70.3 million associated with Hilltop’s existing investment in SWS common stock. Additionally, due to appraisal rights proceedings filed in connection with the SWS Merger, the merger consideration is subject to change, and is therefore, preliminary as of the date of this report. Based on preliminary purchase date valuations, the fair value of the assets acquired was $3.3 billion, including $707.5 million in securities, $863.8 million in non-covered loans and $1.2 billion in broker-dealer and clearing organization receivables. The fair value of liabilities assumed was $2.9 billion, consisting primarily of deposits of $1.3 billion and $1.1 billion in broker-dealer and clearing organization payables.

 

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, 2014 (“2014 Form 10-K”). Results for interim periods are not necessarily indicative of results to be expected for a full year or any future period.

 

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

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

financial instruments, the amounts receivable under the loss-share agreements with the Federal Deposit Insurance Corporation (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. As discussed in Note 2 to the consolidated financial statements, the SWS Merger purchase date valuations associated with loans, intangibles and taxes are considered preliminary because management’s review and approval of certain key assumptions is not complete.

 

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. and has a 100% membership interest in PlainsCapital Securities, LLC.

 

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

 

Hilltop has a 100% membership interest in Hilltop Securities, which operates through its wholly-owned subsidiaries, First Southwest Holdings, LLC (“First Southwest”), Southwest Securities and SWS Financial (collectively, the “Hilltop Broker-Dealers”). The principal subsidiaries of First Southwest are First Southwest Company, LLC (“FSC”), a broker-dealer registered with the Securities and Exchange Commission (the “SEC”) and the Financial Industry Regulatory Authority (“FINRA”) and a member of the New York Stock Exchange (“NYSE”), and First Southwest Asset Management, LLC, a registered investment advisor under the Investment Advisors Act of 1940. Southwest Securities is a broker-dealer registered with the SEC and FINRA and a member of the NYSE, and SWS Financial is an introducing broker-dealer that is also registered with the SEC and FINRA.

 

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

 

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. Acquisition

 

SWS Merger

 

On January 1, 2015, Hilltop completed its acquisition of SWS in a stock and cash transaction as discussed in Note 1 to the consolidated financial statements. The operations of SWS are included in the Company’s operating results beginning January 1, 2015. Such operating results include a preliminary bargain purchase gain of $82.8 million and are not indicative of future operating results. SWS’s results of operations prior to the acquisition date are not included in the Company’s consolidated operating results.

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

The SWS Merger was accounted for using the acquisition method of accounting, and accordingly, purchased assets, including identifiable intangible assets, and assumed liabilities were recorded at their respective acquisition date fair values. The components of the consideration paid are shown in the following table (in thousands).

 

Fair value of preliminary consideration paid:
Common stock issued		$	200,626
Cash		78,217
Fair value of Hilltop’s existing investment in SWS		70,282
Total preliminary consideration paid		$	349,125

 

The resulting preliminary fair values of the identifiable assets acquired, and liabilities assumed, of SWS at January 1, 2015 are summarized in the following table (in thousands).

 

Cash and due from banks		$	119,314
Securities purchased under agreements to resell		44,741
Assets segregated for regulatory purposes		181,610
Securities		707,476
Non-covered loans, net		863,819
Broker-dealer and clearing organization receivables		1,221,793
Other assets		159,753
Total identifiable assets acquired		3,298,506
Deposits		(1,287,509		)
Broker-dealer and clearing organization payables		(1,109,978		)
Short-term borrowings		(164,240		)
Securities sold, not yet purchased, at fair value		(140,409		)
Notes payable		(76,643		)
Other liabilities		(87,786		)
Total liabilities assumed		(2,866,565		)
Preliminary bargain purchase gain		(82,816		)
		349,125
Less Hilltop’s existing investment in SWS		(70,282		)
Net identifiable assets acquired		$	278,843

 

The preliminary bargain purchase gain represents the excess of the preliminary estimated fair value of the underlying net tangible assets and intangible assets over the preliminary merger consideration. The SWS Merger was a tax-free reorganization under Section 368(a) of the Internal Revenue Code, therefore no income taxes were recorded in connection with the preliminary bargain purchase gain. The Company used significant estimates and assumptions to value certain identifiable assets acquired and liabilities assumed. Because of management’s review and approval of certain key assumptions not being complete, the purchase date valuations related to loans, intangibles and taxes are considered preliminary and could differ significantly when finalized.  The preliminary bargain purchase gain was primarily driven by the Company’s ability to realize acquired deferred tax assets through its consolidated core earnings and the decline in the price of the Company’s common stock between the date the fixed conversion ratio was agreed upon and the closing date.

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

Included within the fair value of other assets in the table above are identifiable intangible assets recorded in connection with the SWS Merger. The preliminary allocation to intangible assets is as follows (in thousands).

 

		Estimated Useful		Gross Intangible
		Life (Years)		Assets
Customer relationships		14		$	10,700
Core deposits		4		160
				$	10,860

 

During the three months ended March 31, 2015, transaction and integration related expenses of $10.0 million associated with the SWS Merger are included in noninterest expense within the consolidated statement of operations. Such expenses were for professional services and other incremental employee costs associated with the integration of SWS’s operations. SWS Merger-related transaction expenses during the three months ended March 31, 2014 were nominal.

 

In connection with the SWS Merger, Hilltop acquired loans both with and without evidence of credit quality deterioration since origination. The acquired loans were initially recorded at fair value with no carryover of any allowance for loan losses. Acquired loans were segregated between those considered to be purchased credit impaired (“PCI”) loans and those without credit impairment at acquisition. The following table presents details on acquired loans at the acquisition date (in thousands).

 

		Loans, excluding			PCI			Total
		PCI Loans			Loans			Loans
Commercial and industrial (1)		$	447,959		$	9,850		$	457,809
Real estate		324,477			62,218			386,695
Construction and land development		14,708			1,391			16,099
Consumer		3,216			—			3,216
Total		$	790,360		$	73,459		$	863,819

 

(1)  Acquired loans include margin loans to customers and correspondents of $269.4 million associated with acquired broker-dealer operations, none of which are PCI loans.

 

The following table presents information about the PCI loans at acquisition (in thousands).

 

Contractually required principal and interest payments		$	120,078
Nonaccretable difference		32,040
Cash flows expected to be collected		88,038
Accretable difference		14,579
Fair value of loans acquired with a deterioration of credit quality		$	73,459

 

The following table presents information about the acquired loans without credit impairment at acquisition (in thousands).

 

Contractually required principal and interest payments		$	901,672
Contractual cash flows not expected to be collected		39,721
Fair value at acquisition		790,360

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

Pro Forma Results of Operations

 

The results of operations acquired in the SWS Merger have been included in the Company’s consolidated financial results since January 1, 2015. The following table discloses the impact of SWS on the Company’s results of operations. The table presents pro forma results had the SWS Merger taken place on January 1, 2014 and includes the estimated impact of purchase accounting adjustments (in thousands). The purchase accounting adjustments reflect the impact of recording the acquired loans at fair value, including the estimated accretion of the purchase discount on the loan portfolio. Accretion estimates were based on the acquisition date purchase discount on the loan portfolio, as it was not practicable to determine the amount of discount that would have been recorded based on economic conditions that existed on January 1, 2014. The pro forma results do not include any potential operating cost savings as a result of the SWS Merger. Further, certain costs associated with any restructuring or integration activities are also not reflected in the pro forma results. Pro forma results exclude nonrecurring items resulting directly from the SWS Merger and that do not have a continuing impact on results of operations. The pro forma results are not indicative of what would have occurred had the SWS Merger taken place on the indicated date.

 

		Three
		Months Ended
		March 31, 2014
Net interest income		$	99,842
Other revenues		225,315
Net income		24,658

 

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”) asset 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. At March 31, 2015, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.19 billion, and the unpaid principal balance of those loans was $1.14 billion. At December 31, 2014, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.27 billion, and the unpaid principal balance of those loans was $1.22 billion. The interest component of fair value is reported as interest income on loans in the accompanying consolidated statements of operations.

 

On October 2, 2014, Hilltop exercised its warrant to purchase 8,695,652 shares of SWS common stock at an exercise price of $5.75 per share (the “SWS Warrant”) and paid the aggregate exercise price by the automatic elimination of the $50.0 million aggregate principal amount note due to Hilltop under its credit agreement with SWS. Following the exercise of the SWS Warrant, Hilltop owned approximately 21% of the outstanding shares of SWS common stock as of October 2, 2014. Contemporaneous with the exercise of the SWS Warrant, Hilltop changed the accounting method for its investment in SWS common stock and elected to account for its investment in accordance with the provisions of the Fair Value Option as permitted by GAAP. Hilltop had previously accounted for its investment in SWS common stock as an available for sale security. Under the Fair Value Option, Hilltop’s investment in SWS common stock is recorded at fair value effective October 2, 2014, with changes in fair value being recorded in other noninterest income within the consolidated statement of operations rather than as a component of other comprehensive income. At December 31, 2014, the fair value of Hilltop’s investment in SWS common stock was $70.3 million and is included in other assets within the consolidated balance sheet.

 

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
March 31, 2015		Inputs			Inputs			Inputs			Fair Value
Trading securities		$	40		$	314,181		$	5,932		$	320,153
Available for sale securities		14,070			845,142			—			859,212
Loans held for sale		—			1,168,757			19,495			1,188,252
Derivative assets		—			49,649			—			49,649
MSR asset		—			—			31,648			31,648
Trading liabilities		—			139,481			—			139,481
Derivative liabilities		—			22,048			—			22,048

 

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

 

		Level 1			Level 2			Level 3			Total
December 31, 2014		Inputs			Inputs			Inputs			Fair Value
Trading securities		$	39		$	65,678		$	—		$	65,717
Available for sale securities		13,762			911,773			—			925,535
Loans held for sale		—			1,263,135			9,017			1,272,152
Derivative assets		—			23,805			—			23,805
MSR asset		—			—			36,155			36,155
Investment in SWS common stock		70,282			—			—			70,282
Trading liabilities		—			48			—			48
Derivative liabilities		—			12,849			—			12,849

 

The following tables include a rollforward 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 March 31, 2015
Trading securities		$	—		$	7,301		$	—		$	(1,369	)	$	—		$	5,932
Loans held for sale		9,017			11,136			(271		)	(387		)	—			19,495
Mortgage servicing rights asset		36,155			2,690			—			(7,197		)	—			31,648
Total		$	45,172		$	21,127		$	(271	)	$	(8,953	)	$	—		$	57,075
Three months ended March 31, 2014
Available for sale securities		$	60,053		$	—		$	—		$	593		$	3,452		$	64,098
Loans held for sale		27,729			4,900			(5,594		)	(209		)	—			26,826
Mortgage servicing rights asset		20,149			7,432			—			2,358			—			29,939
Derivative liabilities		(5,600		)	—			—			(350		)	—			(5,950		)
Total		$	102,331		$	12,332		$	(5,594	)	$	2,392		$	3,452		$	114,913

 

All net realized and unrealized gains (losses) in the table above are reflected in the accompanying consolidated financial statements. The available for sale securities noted in the table above reflect Hilltop’s note receivable from SWS and the SWS Warrant. On October 2, 2014, as previously discussed, Hilltop exercised the SWS Warrant in full and paid the aggregate exercise price by the automatic elimination of the $50.0 million aggregate principal amount note due to Hilltop under the credit agreement.

 

For Level 3 financial instruments measured at fair value on a recurring basis at March 31, 2015, the significant unobservable inputs used in the fair value measurements were as follows.

 

						Range (Weighted-
Financial instrument		Valuation Technique		Unobservable Input		Average)
Trading securities		Discounted cash flow		Discount rate		8 - 17% (10%)
Loans held for sale		Discounted cash flow / Market comparable		Projected price		90 - 94% (93%)
Mortgage servicing rights asset		Discounted cash flow		Constant prepayment rate		14.95%
				Discount rate		10.98%

 

The fair value of certain loans held for sale that are either non-standard (i.e. loans that cannot be sold through normal sale channels) or non-performing is measured using unobservable inputs. The fair value of such loans is generally based upon estimates of expected cash flows using unobservable inputs including listing prices of comparable assets, uncorroborated expert opinions, and/or management’s knowledge of underlying collateral.

 

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