Bank segment

Selected financial information

American Savings Bank, F.S.B.

Statements of Income Data



	Three months ended March 31
(in thousands)	2014		2013
Interest and dividend income
Interest and fees on loans	$	43,682	$	42,603
Interest and dividends on investment and mortgage-related securities	3,035		3,464
Total interest and dividend income	46,717		46,067
Interest expense
Interest on deposit liabilities	1,225		1,312
Interest on other borrowings	1,405		1,164
Total interest expense	2,630		2,476
Net interest income	44,087		43,591
Provision for loan losses	995		1,858
Net interest income after provision for loan losses	43,092		41,733
Noninterest income
Fees from other financial services	5,128		7,643
Fee income on deposit liabilities	4,421		4,314
Fee income on other financial products	2,290		1,794
Mortgage banking income	628		3,346
Gain on sale of securities	2,847		—
Other income, net	1,588		1,592
Total noninterest income	16,902		18,689
Noninterest expense
Compensation and employee benefits	20,286		20,088
Occupancy	3,953		4,123
Data processing	3,060		2,987
Services	2,273		2,103
Equipment	1,645		1,774
Other expense	7,153		7,595
Total noninterest expense	38,370		38,670
Income before income taxes	21,624		21,752
Income taxes	7,085		7,597
Net income	$	14,539	$	14,155

American Savings Bank, F.S.B.

Statements of Comprehensive Income Data



	Three months ended March 31
(in thousands)	2014			2013
Net income	$	14,539		$	14,155
Other comprehensive income (loss), net of taxes:
Net unrealized gains (losses) on securities:
Net unrealized gains (losses) on securities arising during the period, net of (taxes) benefits, of ($1,664) and $547 for the respective periods	2,520			(828		)
Less: reclassification adjustment for net realized gains included in net income, net of taxes, of $1,132 and nil for the respective periods	(1,715		)	—
Retirement benefit plans:
Less: amortization of prior service credit and net losses recognized during the period in net periodic benefit cost, net of tax benefits of $144 and $1,424 for the respective periods	219			2,157
Other comprehensive income, net of taxes	1,024			1,329
Comprehensive income	$	15,563		$	15,484

American Savings Bank, F.S.B.

Balance Sheets Data



(in thousands)	March 31, 2014						December 31, 2013
Assets
Cash and cash equivalents (including $40 million of securities purchased under resale agreements at March 31, 2014)				$	251,083					$	156,603
Available-for-sale investment and mortgage-related securities				517,534						529,007
Investment in stock of Federal Home Loan Bank of Seattle				86,697						92,546
Loans receivable held for investment				4,188,460						4,150,229
Allowance for loan losses				(40,923		)				(40,116		)
Loans receivable held for investment, net				4,147,537						4,110,113
Loans held for sale, at lower of cost or fair value				4,363						5,302
Other				282,079						268,063
Goodwill				82,190						82,190
Total assets				$	5,371,483					$	5,243,824

Liabilities and shareholder’s equity
Deposit liabilities—noninterest-bearing				$	1,284,957					$	1,214,418
Deposit liabilities—interest-bearing				3,193,030						3,158,059
Other borrowings				244,642						244,514
Other				120,324						105,679
Total liabilities				4,842,953						4,722,670
Commitments and contingencies (see “Litigation” below)
Common stock				336,617						336,054
Retained earnings				203,086						197,297
Accumulated other comprehensive loss, net of tax benefits
Net unrealized losses on securities	$	(2,858	)				$	(3,663	)
Retirement benefit plans	(8,315		)	(11,173		)	(8,534		)	(12,197		)
Total shareholder’s equity				528,530						521,154
Total liabilities and shareholder’s equity				$	5,371,483					$	5,243,824

Other assets
Bank-owned life insurance				$	130,977					$	129,963
Premises and equipment, net				67,628						67,766
Prepaid expenses				4,617						3,616
Accrued interest receivable				13,119						13,133
Mortgage-servicing rights				11,757						11,687
Low-income housing equity investments				24,730						14,543
Real estate acquired in settlement of loans, net				542						1,205
Other				28,709						26,150
				$	282,079					$	268,063
Other liabilities
Accrued expenses				$	26,003					$	19,989
Federal and state income taxes payable				43,110						37,807
Cashier’s checks				25,363						21,110
Advance payments by borrowers				6,084						9,647
Other				19,764						17,126
				$	120,324					$	105,679

Bank-owned life insurance is life insurance purchased by ASB on the lives of certain key employees, with ASB as the beneficiary. The insurance is used to fund employee benefits through tax-free income from increases in the cash value of the policies and insurance proceeds paid to ASB upon an insured’s death.

ASB invests, as a limited partner, in Low-Income Housing Tax Credit (LIHTC) investment partnerships formed for the purpose of providing funding for affordable multifamily rental properties. These properties are rented to qualified low-income tenants, pursuant to Section 42 of the Internal Revenue Code, allowing the properties to be eligible for federal and, for some properties, state tax credits. ASB realizes a return on its investment through reductions in income tax expense that result from tax credits and the deductibility of the operating losses of these partnerships. The partnership agreements are typically structured to meet a required 15-year period of occupancy by qualified low-income tenants. ASB’s exposure is limited to the amount of its investment.

Other borrowings consisted of securities sold under agreements to repurchase and advances from the Federal Home Loan Bank (FHLB) of Seattle of $145 million and $100 million, respectively, as of March 31, 2014 and December 31, 2013.

Securities sold under agreements to repurchase are accounted for as financing transactions and the obligations to repurchase these securities are recorded as liabilities in the balance sheet. All such agreements are subject to master netting arrangements, which provide for conditional right of set-off in case of default by either party; however, ASB presents securities sold under agreements to repurchase on a gross basis in the balance sheet. The following tables present information about the securities sold under agreements to repurchase, including the related collateral received from or pledged to counterparties:



(in millions)	Gross amount of recognized liabilities		Gross amount offset in the Balance Sheet		Net amount of liabilities presented in the Balance Sheet
Repurchase agreements
March 31, 2014	$	145	$	—	$	145
December 31, 2013	145		—		145



	Gross amount not offset in the Balance Sheet
(in millions)	Net amount of liabilities presented in the Balance Sheet		Financial instruments		Cash collateral pledged		Net amount
March 31, 2014
Financial institution	$	50	$	50	$	—	$	—
Commercial account holders	95		95		—		—
Total	$	145	$	145	$	—	$	—

December 31, 2013
Financial institution	$	51	$	51	$	—	$	—
Commercial account holders	94		94		—		—
Total	$	145	$	145	$	—	$	—

Investment and mortgage-related securities portfolio.

Available-for-sale securities. The book value (amortized cost), gross unrealized gains and losses, estimated fair value and gross unrealized losses (fair value and amount by duration of time in which positions have been held in a continuous loss position) for securities held in ASB’s “available-for-sale” portfolio by major security type were as follows:



	Amortized cost		Gross unrealized gains		Gross unrealized losses			Estimated fair value		Gross unrealized losses
										Less than 12 months					12 months or longer
(in thousands)										Fair value		Amount			Fair value		Amount
March 31, 2014
U.S. Treasury and federal agency obligations	$	87,916	$	489	$	(1,885	)	$	86,520	$	44,700	$	(1,508	)	$	4,402	$	(377	)
Mortgage-related securities- FNMA, FHLMC and GNMA	434,364		4,769		(8,119		)	431,014		229,667		(5,807		)	49,547		(2,312		)
Municipal bonds	—		—		—			—		—		—			—		—
	$	522,280	$	5,258	$	(10,004	)	$	517,534	$	274,367	$	(7,315	)	$	53,949	$	(2,689	)

December 31, 2013
Federal agency obligations	$	83,193	$	174	$	(2,394	)	$	80,973	$	70,779	$	(2,394	)	$	—	$	—
Mortgage-related securities- FNMA, FHLMC and GNMA	374,993		4,911		(10,460		)	369,444		228,543		(8,819		)	19,655		(1,641		)
Municipal bonds	76,904		1,826		(140		)	78,590		14,478		(140		)	—		—
	$	535,090	$	6,911	$	(12,994	)	$	529,007	$	313,800	$	(11,353	)	$	19,655	$	(1,641	)

The unrealized losses on ASB’s investments in mortgage-related securities and obligations issued by federal agencies were caused by interest rate movements. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because ASB does not intend to sell the securities and has determined it is more likely than not that it will not be required to sell the investments before recovery of their amortized costs basis, which may be at maturity, ASB did not consider these investments to be other-than-temporarily impaired at March 31, 2014.

The fair values of ASB’s investment securities could decline if interest rates rise or spreads widen.

The following table details the contractual maturities of available-for-sale securities. All positions with variable maturities (e.g. callable debentures and mortgage-related securities) are disclosed based upon the bond’s contractual maturity. Actual maturities will likely differ from these contractual maturities because borrowers have the right to prepay obligations with or without prepayment penalties.



March 31, 2014	Amortized cost		Fair value
(in thousands)
Due in one year or less	$	—	$	—
Due after one year through five years	34,456		34,446
Due after five years through ten years	32,321		32,370
Due after ten years	21,139		19,704
	87,916		86,520
Mortgage-related securities-FNMA,FHLMC and GNMA	434,364		431,014
Total available-for-sale securities	$	522,280	$	517,534

Allowance for loan losses. ASB must maintain an allowance for loan losses that is adequate to absorb estimated probable credit losses associated with its loan portfolio. The allowance for loan losses consists of an allocated portion, which estimates credit losses for specifically identified loans and pools of loans, and an unallocated portion.

The allowance for loan losses (balances and changes) and financing receivables were as follows:



(in thousands)	Residential 1-4 family			Commercial real estate		Home equity line of credit			Residential land			Commercial construction			Residential construction		Commercial loans			Consumer loans			Unallocated			Total
Three months ended March 31, 2014
Allowance for loan losses:
Beginning balance	$	5,534		$	5,059	$	5,229		$	1,817		$	2,397		$	19	$	15,803		$	2,367		$	1,891		$	40,116
Charge-offs	(266		)	—		—			(6		)	—			—		(124		)	(561		)	—			(957		)
Recoveries	341			—		11			86			—			—		100			231			—			769
Provision	(134		)	656		729			(322		)	666			5		(187		)	279			(697		)	995
Ending balance	$	5,475		$	5,715	$	5,969		$	1,575		$	3,063		$	24	$	15,592		$	2,316		$	1,194		$	40,923
Ending balance: individually evaluated for impairment	$	906		$	1,544	$	—		$	1,102		$	—		$	—	$	2,133		$	—		$	—		$	5,685
Ending balance: collectively evaluated for impairment	$	4,569		$	4,171	$	5,969		$	473		$	3,063		$	24	$	13,459		$	2,316		$	1,194		$	35,238
Financing Receivables:
Ending balance	$	1,985,812		$	452,303	$	764,483		$	15,906		$	66,578		$	16,474	$	786,611		$	108,202		$	—		$	4,196,369
Ending balance: individually evaluated for impairment	$	20,141		$	4,558	$	1,164		$	10,351		$	—		$	—	$	19,399		$	18		$	—		$	55,631
Ending balance: collectively evaluated for impairment	$	1,965,671		$	447,745	$	763,319		$	5,555		$	66,578		$	16,474	$	767,212		$	108,184		$	—		$	4,140,738
Three months ended March 31, 2013
Allowance for loan losses:
Beginning balance	$	6,068		$	2,965	$	4,493		$	4,275		$	2,023		$	9	$	15,931		$	4,019		$	2,202		$	41,985
Charge-offs	(210		)	—		(670		)	(227		)	—			—		(426		)	(645		)	—			(2,178		)
Recoveries	192			—		194			137			—			—		392			150			—			1,065
Provision	(39		)	3,691		540			(1,442		)	(151		)	3		(934		)	131			59			1,858
Ending balance	$	6,011		$	6,656	$	4,557		$	2,743		$	1,872		$	12	$	14,963		$	3,655		$	2,261		$	42,730
Ending balance: individually evaluated for impairment	$	454		$	3,169	$	—		$	1,943		$	—		$	—	$	2,285		$	—		$	—		$	7,851
Ending balance: collectively evaluated for impairment	$	5,557		$	3,487	$	4,557		$	800		$	1,872		$	12	$	12,678		$	3,655		$	2,261		$	34,879
Financing Receivables:																										0
Ending balance	$	1,915,207		$	391,679	$	648,904		$	23,894		$	40,698		$	8,275	$	699,918		$	127,260		$	—		$	3,855,835
Ending balance: individually evaluated for impairment	$	25,320		$	10,662	$	1,259		$	17,618		$	—		$	—	$	19,302		$	21		$	—		$	74,182
Ending balance: collectively evaluated for impairment	$	1,889,887		$	381,017	$	647,645		$	6,276		$	40,698		$	8,275	$	680,616		$	127,239		$	—		$	3,781,653

Credit quality. ASB performs an internal loan review and grading on an ongoing basis. The review provides management with periodic information as to the quality of the loan portfolio and effectiveness of its lending policies and procedures. The objectives of the loan review and grading procedures are to identify, in a timely manner, existing or emerging credit trends so that appropriate steps can be initiated to manage risk and avoid or minimize future losses. Loans subject to grading include commercial and industrial, commercial real estate and commercial construction loans.

A dual ten-point risk rating system is used to reflect the probability of default (borrower risk rating) and loss given default (transaction risk rating). The borrower risk rating addresses risk presented by the individual borrower and is based on the overall assessment of the borrower’s financial and operating strength including earnings, operating cash flow, debt service capacity, asset and liability structure, competitive issues, experience and quality of management, financial reporting quality and industry/economic factors. Separately, the transaction risk rating addresses risk in the transaction and is a function of specific loan attributes which impact the ultimate collectability of the loan such as collateral, loan structure, guarantees, and other structural support or enhancements to the loan.

The numerical representation of the risk categories are:



	1- Substantially risk free	6- Acceptable risk
	2- Minimal risk	7- Special mention
	3- Modest risk	8- Substandard
	4- Better than average risk	9- Doubtful
	5- Average risk	10- Loss

Grades 1 through 6 are considered pass grades. Pass exposures generally are well protected by the current net worth and paying capacity of the obligor or by the value of the asset or underlying collateral.

The credit risk profile by internally assigned grade for loans was as follows:



	March 31, 2014						December 31, 2013
(in thousands)	Commercial real estate		Commercial construction		Commercial		Commercial real estate		Commercial construction		Commercial
Grade:
Pass	$	393,888	$	66,578	$	708,268	$	375,217	$	52,112	$	703,053
Special mention	25,651		—		20,315		33,436		—		17,634
Substandard	29,014		—		55,079		28,020		—		59,663
Doubtful	3,750		—		2,949		3,770		—		3,038
Loss	—		—		—		—		—		—
Total	$	452,303	$	66,578	$	786,611	$	440,443	$	52,112	$	783,388

The credit risk profile based on payment activity for loans was as follows:



(in thousands)	30-59 days past due		60-89 days past due		Greater than 90 days		Total past due		Current		Total financing receivables		Recorded investment> 90 days and accruing
March 31, 2014
Real estate loans:
Residential 1-4 family	$	4,209	$	1,635	$	14,321	$	20,165	$	1,965,647	$	1,985,812	$	—
Commercial real estate	71		—		3,750		3,821		448,482		452,303		—
Home equity line of credit	640		98		928		1,666		762,817		764,483		—
Residential land	96		191		2,223		2,510		13,396		15,906		52
Commercial construction	—		—		—		—		66,578		66,578		—
Residential construction	—		—		—		—		16,474		16,474		—
Commercial loans	1,794		5,050		2,406		9,250		777,361		786,611		—
Consumer loans	431		187		163		781		107,421		108,202		—
Total loans	$	7,241	$	7,161	$	23,791	$	38,193	$	4,158,176	$	4,196,369	$	52
December 31, 2013
Real estate loans:
Residential 1-4 family	$	2,728	$	622	$	15,411	$	18,761	$	1,987,246	$	2,006,007	$	—
Commercial real estate	—		—		3,770		3,770		436,673		440,443		—
Home equity line of credit	765		312		960		2,037		737,294		739,331		—
Residential land	184		48		2,756		2,988		13,188		16,176		—
Commercial construction	—		—		—		—		52,112		52,112		—
Residential construction	—		—		—		—		12,774		12,774		—
Commercial loans	1,668		612		3,026		5,306		778,082		783,388		—
Consumer loans	436		158		304		898		107,824		108,722		—
Total loans	$	5,781	$	1,752	$	26,227	$	33,760	$	4,125,193	$	4,158,953	$	—

The credit risk profile based on nonaccrual loans and accruing loans 90 days or more past due was as follows:



	March 31, 2014				December 31, 2013
(in thousands)	Nonaccrual loans		Accruing loans 90 days or more past due		Nonaccrual loans		Accruing loans 90 days or more past due
Real estate loans:
Residential 1-4 family	$	18,795	$	—	$	19,679	$	—
Commercial real estate	4,395		—		4,439		—
Home equity line of credit	2,060		—		2,060		—
Residential land	3,136		52		3,161		—
Commercial construction	—		—		—		—
Residential construction	—		—		—		—
Commercial loans	17,641		—		18,781		—
Consumer loans	310		—		401		—
Total	$	46,337	$	52	$	48,521	$	—

The total carrying amount and the total unpaid principal balance of impaired loans, with and without recorded allowance for loan losses and combined, were as follows:



	March 31, 2014						Three months ended March 31, 2014
(in thousands)	Recorded investment		Unpaid principal balance		Related Allowance		Average recorded investment		Interest income recognized*
With no related allowance recorded
Real estate loans:
Residential 1-4 family	$	9,573	$	11,874	$	—	$	10,480	$	88
Commercial real estate	—		—		—		—		—
Home equity line of credit	641		1,205		—		649		3
Residential land	3,080		4,047		—		3,016		56
Commercial construction	—		—		—		—		—
Residential construction	—		—		—		—		—
Commercial loans	3,320		4,613		—		3,381		—
Consumer loans	18		18		—		18		—
	16,632		21,757		—		17,544		147
With an allowance recorded
Real estate loans:
Residential 1-4 family	6,764		6,784		906		5,605		103
Commercial real estate	4,558		4,668		1,543		4,573		2
Home equity line of credit	—		—		—		—		—
Residential land	7,271		7,442		1,102		7,168		132
Commercial construction	—		—		—		—		—
Residential construction	—		—		—		—		—
Commercial loans	16,079		19,235		2,134		16,550		44
Consumer loans	—		—		—		—		—
	34,672		38,129		5,685		33,896		281
Total
Real estate loans:
Residential 1-4 family	16,337		18,658		906		16,085		191
Commercial real estate	4,558		4,668		1,543		4,573		2
Home equity line of credit	641		1,205		—		649		3
Residential land	10,351		11,489		1,102		10,184		188
Commercial construction	—		—		—		—		—
Residential construction	—		—		—		—		—
Commercial loans	19,399		23,848		2,134		19,931		44
Consumer loans	18		18		—		18		—
	$	51,304	$	59,886	$	5,685	$	51,440	$	428



	December 31, 2013						Year ended December 31, 2013
(in thousands)	Recorded investment		Unpaid principal balance		Related allowance		Average recorded investment		Interest income recognized*
With no related allowance recorded
Real estate loans:
Residential 1-4 family	$	9,708	$	12,144	$	—	$	11,674	$	386
Commercial real estate	—		—		—		802		—
Home equity line of credit	672		1,227		—		623		2
Residential land	2,622		3,612		—		6,675		482
Commercial construction	—		—		—		—		—
Residential construction	—		—		—		—		—
Commercial loans	3,466		4,715		—		4,837		12
Consumer loans	19		19		—		20		—
	16,487		21,717		—		24,631		882
With an allowance recorded
Real estate loans:
Residential 1-4 family	6,216		6,236		642		6,455		372
Commercial real estate	4,604		4,686		1,118		5,745		152
Home equity line of credit	—		—		—		—		—
Residential land	7,452		7,623		1,332		6,844		409
Commercial construction	—		—		—		—		—
Residential construction	—		—		—		—		—
Commercial loans	17,759		20,640		2,246		15,635		139
Consumer loans	—		—		—		—		—
	36,031		39,185		5,338		34,679		1,072
Total
Real estate loans:
Residential 1-4 family	15,924		18,380		642		18,129		758
Commercial real estate	4,604		4,686		1,118		6,547		152
Home equity line of credit	672		1,227		—		623		2
Residential land	10,074		11,235		1,332		13,519		891
Commercial construction	—		—		—		—		—
Residential construction	—		—		—		—		—
Commercial loans	21,225		25,355		2,246		20,472		151
Consumer loans	19		19		—		20		—
	$	52,518	$	60,902	$	5,338	$	59,310	$	1,954

* Since loan was classified as impaired.

Troubled debt restructurings. A loan modification is deemed to be a troubled debt restructuring (TDR) when ASB grants a concession it would not otherwise consider were it not for the borrower’s financial difficulty. When a borrower experiencing financial difficulty fails to make a required payment on a loan or is in imminent default, ASB takes a number of steps to improve the collectability of the loan and maximize the likelihood of full repayment. At times, ASB may modify or restructure a loan to help a distressed borrower improve its financial position to eventually be able to fully repay the loan, provided the borrower has demonstrated both the willingness and the ability to fulfill the modified terms. TDR loans are considered an alternative to foreclosure or liquidation with the goal of minimizing losses to ASB and maximizing recovery.

ASB may consider various types of concessions in granting a TDR including maturity date extensions, extended amortization of principal, temporary deferral of principal payments, and temporary interest rate reductions. ASB rarely grants principal forgiveness in its TDR modifications. Residential loan modifications generally involve interest rate reduction, extending the amortization period, or capitalizing certain delinquent amounts owed not to exceed the original loan balance. Land loans at origination are typically structured as a three-year term, interest-only monthly payment with a balloon payment due at maturity. Land loan TDR modifications typically involve extending the maturity date up to five years and converting the payments from interest-only to principal and interest monthly, at the same or higher interest rate. Commercial loan modifications generally involve extensions of maturity dates, extending the amortization period, and temporary deferral of principal payments. ASB generally does not reduce the interest rate on commercial loan TDR modifications. Occasionally, additional collateral and/or guaranties are obtained.

All TDR loans are classified as impaired and are segregated and reviewed separately when assessing the adequacy of the allowance for loan losses based on the appropriate method of measuring impairment: (1) present value of expected future cash flows discounted at the loan’s effective original contractual rate, (2) fair value of collateral less cost to sell, or (3) observable market price. The financial impact of the calculated impairment amount is an increase to the allowance associated with the modified loan. When available information confirms that specific loans or portions thereof are uncollectible (confirmed losses), these amounts are charged off against the allowance for loan losses.

Loan modifications that occurred were as follows for the indicated periods:



	Three months ended March 31, 2014					Three months ended March 31, 2013
	Number of	Outstanding recorded investment				Number of	Outstanding recorded investment
(dollars in thousands)	contracts	Pre-modification		Post-modification		contracts	Pre-modification		Post-modification
Troubled debt restructurings
Real estate loans:
Residential 1-4 family	5	$	921	$	935	4	$	1,122	$	1,063
Commercial real estate	—	—		—		—	—		—
Home equity line of credit	—	—		—		4	462		215
Residential land	7	1,133		1,133		3	924		868
Commercial loans	3	473		473		—	—		—
Consumer loans	—	—		—		—	—		—
	15	$	2,527	$	2,541	11	$	2,508	$	2,146

There were no loans modified in TDRs that experienced a payment default of 90 days or more in the first quarters of 2014 and 2013, and for which the payment default occurred within one year of the modification.

If loans modified in a TDR subsequently default, ASB evaluates the loan for further impairment. Based on its evaluation, adjustments may be made in the allocation of the allowance or partial charge-offs may be taken to further write-down the carrying value of the loan. Commitments to lend additional funds to borrowers whose loans have been designated impaired or whose terms have been modified in TDRs totaled $0.3 million as of March 31, 2014.

Amortized intangible assets. The table below presents the gross carrying amount, accumulated amortization, valuation allowance and net carrying amount of ASB’s mortgage servicing assets as of March 31, 2014 and 2013:



March 31	2014								2013
(in thousands)	Gross carrying amount		Accumulated amortization		Valuation allowance		Net carrying amount		Gross carrying amount		Accumulated amortization		Valuation allowance		Net carrying amount
Mortgage servicing assets	$	26,097	(14,138	)	(202	)	$	11,757	$	24,150	(12,399	)	(351	)	$	11,400

Changes in the valuation allowance for mortgage servicing assets were as follows:



(in thousands)	2014			2013
Valuation allowance, January 1	$	251		$	498
Provision (recovery)	(35		)	(107		)
Other-than-temporary impairment	(14		)	(40		)
Valuation allowance, March 31	$	202		$	351

ASB recognizes a mortgage servicing asset when a mortgage loan is sold with servicing rights retained. This mortgage servicing right (MSR) is initially capitalized at its presumed fair value based on market data at the time of sale and accounted for in subsequent periods at the lower of amortized cost or fair value. The MSR is amortized in proportion to and over the period of estimated net servicing income and assessed for impairment at each reporting date.

ASB stratifies the MSR based on predominant risk characteristics of the underlying loans including loan type and note rate. For each stratum, fair value is calculated by discounting expected net income streams using discount rates that reflect industry pricing for similar assets. Expected net income streams are estimated based on industry assumptions regarding prepayment expectations and income and expenses associated with servicing residential mortgage loans for others.

Impairment is recognized through a valuation allowance for each stratum when the carrying amount exceeds fair value, with any associated provision recorded as a component of loan servicing fees included in ASB’s noninterest income. A direct write-down is recorded when the recoverability of the valuation allowance is deemed to be unrecoverable.

Key assumptions used in estimating the fair value of the bank’s mortgage servicing rights were as follows:



	March 31, 2014			March 31, 2013
Unpaid principal balance (000s)	$	1,382,731		$	1,305,811
Weighted average note-rate	4.07		%	4.11		%
Weighted average discount rate	9.8		%	9.7		%
Weighted average prepayment speed	8.7		%	10.8		%

Derivative Financial Instruments. ASB enters into interest rate lock commitments with borrowers, and forward commitments to sell loans or to-be-announced mortgage-backed securities to investors to hedge against the inherent interest rate and pricing risk associated with selling loans.

ASB enters into interest rate lock commitments (IRLCs) for residential mortgage loans, which commit ASB to lend funds to a potential borrower at a specific interest rate and within a specified period of time. IRLCs that relate to the origination of mortgage loans that will be held for sale are considered derivative financial instruments under applicable accounting guidance. Outstanding IRLCs expose ASB to the risk that the price of the mortgage loans underlying the commitments may decline due to increases in mortgage interest rates from inception of the rate lock to the funding of the loan. The IRLCs are free-standing derivatives which are carried at fair value with changes recorded in mortgage banking income.

ASB enters into forward commitments to hedge the interest rate risk for rate locked mortgage applications in process and closed mortgage loans held for sale. These commitments are primarily forward sales of to-be-announced mortgage backed securities. Generally, when mortgage loans are closed, the forward commitment is liquidated and replaced with a mandatory delivery forward sale of the mortgage to a secondary market investor. In some cases, a best-efforts forward sale agreement is utilized as the forward commitment. These commitments are free-standing derivatives which are carried at fair value with changes recorded in mortgage banking income.

Changes in the fair value of IRLCs and forward commitments subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.

The notional amount and fair value of ASB’s derivative financial instruments as of March 31, 2014 and December 31, 2013 were as follows:



	March 31, 2014				December 31, 2013
(dollars in thousands)	Notional amount		Fair value		Notional amount		Fair value
Interest rate lock commitments	$	17,871	$	194	$	25,070	$	464
Forward commitments	19,693		33		26,018		139

The following table presents ASB’s derivative financial instruments, their fair values, and balance sheet location as of March 31, 2014 and December 31, 2013:



Derivative Financial Instruments Not Designated
as Hedging Instruments ¹	March 31, 2014				December 31, 2013
(dollars in thousands)	Derivative asset		Derivative liability		Derivative asset		Derivative liability
Interest rate lock commitments	$	199	$	5	$	488	$	24
Forward commitments	35		2		141		2
	$	234	$	7	$	629	$	26

¹ Derivative assets are included in other assets and derivative liabilities are included in other liabilities in the balance sheets.

The following table presents ASB’s derivative financial instruments and the amount and location of the net gains or losses recognized in the statements of income for the three months ended March 31, 2014 and 2013.



Derivative Financial Instruments Not Designated	Location of net gains
as Hedging Instruments	(losses) recognized in	Three months ended March 31
(dollars in thousands)	the Statement of Income	2014			2013
Interest rate lock commitments	Mortgage banking income	$	(270	)	$	—
Forward commitments	Mortgage banking income	(106		)	—
		$	(376	)	$	—

Litigation. In March 2011, a purported class action lawsuit was filed in the First Circuit Court of the state of Hawaii by a customer who claimed that ASB had improperly charged overdraft fees on debit card transactions. The lawsuit is still in its preliminary stage. ASB filed a motion to dismiss the lawsuit on the basis that as a bank chartered under federal law, ASB believes its business practices are governed by federal regulations established for federal savings banks and not by state law. In July 2011, the Circuit Court denied ASB’s motion and ASB appealed that decision. ASB’s appeal is currently pending before the Hawaii Supreme Court. The probable outcome and range of reasonably possible loss remains indeterminable at this time.

ASB is subject in the normal course of business to pending and threatened legal proceedings. Management does not anticipate that the aggregate ultimate liability arising out of these pending or threatened legal proceedings will be material to its financial position. However, ASB cannot rule out the possibility that such outcomes could have a material adverse effect on the results of operations or liquidity for a particular reporting period in the future.