5. Mortgage Banking and Servicing Rights

Mortgage banking activities primarily include residential mortgage originations and servicing. As discussed in note 1 above, mortgage servicing rights (“MSRs”) are carried at fair market value. The fair value is determined quarterly based on an independent third-party valuation using a discounted cash flow analysis and calculated using a computer pricing model. The system used in this evaluation, Compass Point, attempts to quantify loan level idiosyncratic risk by calculating a risk derived value. As a result, each loan’s unique characteristics determine the valuation assumptions ascribed to that loan. Additionally, the computer valuation is based on key economic assumptions including the prepayment speeds of the underlying loans generated using the Andrew Davidson Prepayment Model, FHLMC/FNMA guidelines, the weighted-average life of the loan, the discount rate, the weighted-average coupon, and the weighted-average default rate, as applicable. Along with the gains received from the sale of loans, fees are received for servicing loans. These fees include late fees, which are recorded in interest income, and ancillary fees and monthly servicing fees, which are recorded in noninterest income. Costs of servicing loans are charged to expense as incurred. Changes in fair market value of the MSRs are reported as an increase or decrease to mortgage banking income.

The following table presents the components of mortgage banking income:

(in thousands) Year Ended December 31	2013		2012			2011
Net gain on sale of loans held for sale	$	3,098	$	2,562		$	1,749
Net loan servicing income (expense)
Servicing fees		1,121		1,083			1,072
Late fees		98		83			77
Ancillary fees		368		382			278
Fair value adjustments		206		(559	)		(1,405	)
Net loan servicing income		1,793		989			22
Mortgage banking income	$	4,891	$	3,551		$	1,771

Mortgage loans serviced for others are not included in the accompanying balance sheets. Loans serviced for the benefit of others (primarily FHLMC) totaled $440 million, $419 million, and $425 million at December 31, 2013, 2012 and 2011, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors, and processing foreclosures. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately $855 thousand, $673 thousand, and $579 thousand at December 31, 2013, 2012, and 2011, respectively.

Activity for capitalized mortgage servicing rights using the fair value method is as follows:

(in thousands)	2013			2012			2011
Fair value of MSRs, beginning of period	$	2,364		$	2,282		$	3,161
New servicing assets created		854			641			526
Change in fair value during the period due to:
Time decay (1)		(159	)		(116	)		(124	)
Payoffs (2)		(423	)		(478	)		(439	)
Changes in valuation inputs or assumptions (3)		788			35			(842	)
Fair value of MSRs, end of period	$	3,424		$	2,364		$	2,282

(1)	Represents decrease in value due to regularly scheduled loan principal payments and partial loan paydowns.

(2)	Represents decrease in value due to loans that paid off during the period.

(3)	Represents change in value resulting from market-driven changes in interest rates.

The fair values of capitalized mortgage servicing rights were $3.4 million, $2.4 million, and $2.3 million at December 31, 2013, 2012, and 2011, respectively. Fair values were determined by third-party valuations using a discount rate of 10.0%, 10.5%, and 10.0%, for the years ended December 31, 2013, 2012, and 2011, respectively, and weighted average default rates of 3.36%, 2.65%, and 2.61%, respectively. Prepayment speeds generated using the Andrew Davidson Prepayment Model averaged 9.7%, 16.3%, and 19.2% at December 31, 2013, 2012, and 2011, respectively. These assumptions are prepared by the third party provider and reviewed and approved by management prior to final determination of the fair value. MSR values are very sensitive to movement in interest rates as expected future net servicing income depends on the projected balance of the underlying loans, which can be greatly impacted by the level of prepayments. CTBI does not currently hedge against changes in the fair value of its MSR portfolio.