17. FAIR VALUE OF FINANCIAL ASSETS AND LIABILITIES

Disclosures about Fair Value of Financial Instruments

Fair value estimates, methods and assumptions are set forth below for our financial instruments.

Short-Term Financial Instruments

The carrying values of short-term financial instruments are deemed to approximate fair values. Such instruments are considered readily convertible to cash and include cash and due from banks, interest-bearing deposits in other banks, accrued interest receivable, the majority of short-term borrowings and accrued interest payable.

Investment Securities

The fair value of investment securities is based on market price quotations received from securities dealers. Where quoted market prices are not available, fair values are based on quoted market prices of comparable securities.

Loans

Fair values of loans are estimated based on discounted cash flows of portfolios of loans with similar financial characteristics including the type of loan, interest terms and repayment history. Fair values are calculated by discounting scheduled cash flows through estimated maturities using estimated market discount rates. Estimated market discount rates are reflective of credit and interest rate risks inherent in the Company’s various loan types and are derived from available market information, as well as specific borrower information. The fair value of loans are not based on the notion of exit price.

Loans Held for Sale

The fair value of loans classified as held for sale are generally based upon quoted prices for similar assets in active markets, acceptance of firm offer letters with agreed upon purchase prices, discounted cash flow models that take into account market observable assumptions, or independent appraisals of the underlying collateral securing the loans. We report the fair values of Hawaii and U.S. Mainland construction and commercial real estate loans net of applicable selling costs on our consolidated balance sheets.

Other Interest Earning Assets

The equity investment in common stock of the FHLB, which is redeemable for cash at par value, is reported at its par value.

Deposit Liabilities

The fair values of deposits with no stated maturity, such as noninterest-bearing demand deposits and interest-bearing demand and savings accounts, are equal to the amount payable on demand. The fair value of time deposits is estimated using discounted cash flow analyses. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-Term Borrowings and Long-Term Debt

The fair value of short-term borrowings is estimated by discounting scheduled cash flows using rates currently offered for securities of similar remaining maturities. The fair value of our long-term debt is estimated by discounting scheduled cash flows over the contractual borrowing period at the estimated market rate for similar borrowing arrangements.

Off-Balance Sheet Financial Instruments

The fair values of off-balance sheet financial instruments are estimated based on the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties, current settlement values or quoted market prices of comparable instruments.

For derivative financial instruments, the fair values are based upon current settlement values, if available. If there are no relevant comparables, fair values are based on pricing models using current assumptions for interest rate swaps and options.

Limitations

Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. Because no market exists for a significant portion of our financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of future business and the value of assets and liabilities that are not considered financial instruments. For example, significant assets and liabilities that are not considered financial assets or liabilities include deferred tax assets, premises and equipment and intangible assets. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates.

						Fair Value Measurement Using
						Quoted Prices in		Significant			Significant
						Active Markets for		Other Observable			Unobservable
	Carrying		Estimated			Identical Assets		Inputs			Inputs
	Amount		Fair Value			(Level 1)		(Level 2)			(Level 3)
	(Dollars in thousands)
September 30, 2013
Financial assets
Cash and due from banks	$	59,400	$	59,400		$	59,400	$	—		$	—
Interest-bearing deposits in other banks	37,499		37,499			37,499		—			—
Investment securities	1,757,611		1,747,467			838		1,737,054			9,575
Loans held for sale	12,437		12,437			—		—			12,437
Net loans and leases	2,399,090		2,240,519			—		79,320			2,161,199
Accrued interest receivable	13,765		13,765			13,765		—			—

Financial liabilities
Deposits:
Noninterest-bearing deposits	878,262		878,262			878,262		—			—
Interest-bearing demand and savings deposits	1,951,909		1,951,909			1,951,909		—			—
Time deposits	1,076,093		1,077,758			—		—			1,077,758
Short-term debt	28,000		28,000			—		28,000			—
Long-term debt	108,268		43,853			—		43,853			—
Accrued interest payable (included in other liabilities)	1,277		1,277			1,277		—			—

Off-balance sheet financial instruments
Commitments to extend credit	600,240		3,001			—		3,001			—
Standby letters of credit and financial guarantees written	18,864		141			—		141			—
Interest rate options	40,090		914			—		914			—
Forward interest rate contracts	41,492		(660		)	—		(660		)	—

December 31, 2012
Financial assets
Cash and due from banks	$	56,473	$	56,473		$	56,473	$	—		$	—
Interest-bearing deposits in other banks	120,902		120,902			120,902		—			—
Investment securities	1,698,593		1,699,273			906		1,685,541			12,826
Loans held for sale	38,283		38,283			—		—			38,283
Net loans and leases	2,107,531		2,083,514			—		108,081			1,975,433
Accrued interest receivable	13,896		13,896			13,896		—			—

Financial liabilities
Deposits:
Noninterest-bearing deposits	843,292		843,292			843,292		—			—
Interest-bearing demand and savings deposits	1,858,849		1,858,849			1,858,849		—			—
Time deposits	978,631		981,059			—		—			981,059
Long-term debt	108,281		43,156			—		43,156			—
Accrued interest payable (included in other liabilities)	13,131		13,131			13,131		—			—

Off-balance sheet financial instruments
Commitments to extend credit	554,477		2,772			—		2,772			—
Standby letters of credit and financial guarantees written	13,813		104			—		104			—
Interest rate options	67,072		106			—		106			—
Forward interest rate contracts	49,222		(353		)	—		(353		)	—

Fair Value Measurements

We group our financial assets and liabilities at fair value into three levels based on the markets in which the financial assets and liabilities are traded and the reliability of the assumptions used to determine fair value as follows:

· Level 1 — Valuation is based upon quoted prices (unadjusted) for identical assets or liabilities traded in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

· Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

· Level 3 — Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of discounted cash flow models and similar techniques that requires the use of significant judgment or estimation.

We base our fair values on the price that we would expect to receive if an asset were sold or pay to transfer a liability in an orderly transaction between market participants at the measurement date. We also maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.

We use fair value measurements to record adjustments to certain financial assets and liabilities and to determine fair value disclosures. Available for sale securities and derivatives are recorded at fair value on a recurring basis. From time to time, we may be required to record other financial assets at fair value on a nonrecurring basis such as loans held for sale, impaired loans and mortgage servicing rights. These nonrecurring fair value adjustments typically involve application of the lower of cost or fair value accounting or write-downs of individual assets.

There were no transfers of financial assets and liabilities between Level 1 and Level 2 of the fair value hierarchy during the three and nine months ended September 30, 2013.

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012:

				Fair Value at Reporting Date Using
				Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs			Significant Unobservable Inputs
	Fair Value			(Level 1)		(Level 2)			(Level 3)
	(Dollars in thousands)
September 30, 2013
Available for sale securities:
Debt securities:
U.S. Government sponsored entities	$	128,392		$	—	$	128,392		$	—
States and political subdivisions	180,024			—		170,449			9,575
Corporations	140,003			—		140,003			—
Mortgage-backed securities:
U.S. Government sponsored entities	973,345			—		973,345			—
Non-agency collateralized mortgage obligations	79,346			—		79,346			—
Other	838			838		—			—
Derivatives:
Interest rate contracts	254			—		254			—
Total	$	1,502,202		$	838	$	1,491,789		$	9,575

December 31, 2012
Available for sale securities:
Debt securities:
U.S. Government sponsored entities	$	280,939		$	—	$	280,939		$	—
States and political subdivisions	185,911			—		173,085			12,826
Corporations	127,946			—		127,946			—
Mortgage-backed securities:
U.S. Government sponsored entities	941,043			—		941,043			—
Other	906			906		—			—
Derivatives:
Interest rate contracts	(248		)	—		(248		)	—
Amended TARP warrant	(819		)	—		(819		)	—
Total	$	1,535,678		$	906	$	1,521,946		$	12,826

For the nine months ended September 30, 2013 and 2012, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:

	Available for sale debt securities - States and political subdivisions
	(Dollars in thousands)

Balance at December 31, 2012	$	12,826
Principal payments received	(2,736		)
Unrealized net loss included in other comprehensive income	(589		)
Purchases, sales, issuances and settlements, net	74
Balance at September 30, 2013	$	9,575

Balance at December 31, 2011	$	12,994
Principal payments received	(285		)
Unrealized net gain included in other comprehensive income	304
Balance at September 30, 2012	$	13,013

Within the state and political subdivisions debt securities category, the Company holds four mortgage revenue bonds issued by the City & County of Honolulu with an aggregate fair value of $9.6 million. The Company estimates the fair value of its mortgage revenue bonds by using a discounted cash flow model to calculate the present value of estimated future principal and interest payments.

The significant unobservable input used in the fair value measurement of the Company’s mortgage revenue bonds is the weighted average discount rate. As of September 30, 2013, the weighted average discount rate utilized was 4.84%, which was derived by incorporating a credit spread over the FHLB Fixed-Rate Advance curve. Significant increases (decreases) in the weighted average discount rate could result in a significantly lower (higher) fair value measurement.

For assets measured at fair value on a nonrecurring basis that were recorded at fair value on our balance sheet at September 30, 2013 and December 31, 2012, the following table provides the level of valuation assumptions used to determine the respective fair values:

			Fair Value Measurements Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Fair Value		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
September 30, 2013
Impaired loans (1)	$	79,320	$	—	$	79,320	$	—
Other real estate (2)	5,761		—		5,761		—

December 31, 2012
Impaired loans (1)	$	108,081	$	—	$	108,081	$	—
Other real estate (2)	10,686		—		10,686		—

(1) Represents carrying value and related write-downs of loans for which adjustments are based on agreed upon purchase prices for the loans or the appraised value of the collateral.

(2) Represents other real estate that is carried at the lower of carrying value or fair value less costs to sell. Fair value is generally based upon independent market prices or appraised values of the collateral.