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 financial institutions, interest-bearing deposits in other financial institutions, accrued interest receivable, the majority of Federal Home Loan Bank advances and other short-term borrowings, and accrued interest payable.

Investment Securities

The fair value of investment securities is based on market price quotations received from third-party pricing services. The third-party pricing services utilize pricing models supported with timely market data information. 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. In accordance with ASU 2016-01, the fair value of loans as of September 30, 2018 are based on the notion of exit price. The fair value of loans as of December 31, 2017 was measured based on the notion of entry 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, if any, net of applicable selling costs on our consolidated balance sheets.

Mortgage Servicing Rights

The initial fair value of mortgage servicing rights is calculated by a discounted cash flow model prepared by a third-party service provider based on market value assumptions at the time of origination. We assess the servicing right for impairment using current market value assumptions at each reporting period. Critical assumptions used in the discounted cash flow model include mortgage prepayment speeds, discount rates, costs to service, and ancillary income. Variations in our assumptions could materially affect the estimated fair values. Changes to our assumptions are made when current trends and market data indicate that new trends have developed. Current market value assumptions based on loan product types (fixed rate, adjustable rate and balloon loans) include average discount rates and prepayment speeds. Many of these assumptions are subjective and require a high level of management judgment. Our mortgage servicing rights portfolio and valuation assumptions are periodically reviewed by management.

Federal Home Loan Bank Stock

It is not practical to determine the fair value of FHLB stock due to the restrictions placed on its transferability.

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.

Long-Term Debt

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.

Derivatives

The fair values of derivative financial instruments are based upon current market 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.

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.

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.



					Fair Value Measurement Using
(dollars in thousands)	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2018
Financial assets
Cash and due from banks	$	82,668	$	82,668	$	82,668	$	—	$	—
Interest-bearing deposits in other banks	7,051		7,051		7,051		—		—
Investment securities	1,386,739		1,380,353		885		1,368,324		11,144
Loans held for sale	4,460		4,460		—		4,460		—
Net loans and leases	3,931,201		3,804,844		—		19,170		3,785,674
Mortgage servicing rights	15,634		18,315		—		—		18,315
Federal Home Loan Bank stock	10,965		N/A		N/A		N/A		N/A

Financial liabilities
Deposits:
Noninterest-bearing demand	1,403,534		1,403,534		1,403,534		—		—
Interest-bearing demand and savings and money market	2,438,595		2,438,595		2,438,595		—		—
Time	1,161,551		1,152,739				—		1,152,739
Short-term borrowings	105,000		105,000		—		105,000		—
Long-term debt	92,785		88,344		—		88,344		—



									Fair Value Measurement Using
(dollars in thousands)	Notional Amount		Carrying Amount			Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
September 30, 2018
Derivatives
Interest rate lock commitments	$	15,463	$	(4	)	$	(4	)	$	—	$	(4	)	$	—
Forward sale commitments	19,861		67			67			—		67			—

Off-balance sheet financial instruments
Commitments to extend credit	1,066,761		—			1,272			—		1,272			—
Standby letters of credit and financial guarantees written	13,465		—			202			—		202			—



					Fair Value Measurement Using
(dollars in thousands)	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
December 31, 2017
Financial assets
Cash and due from banks	$	75,318	$	75,318	$	75,318	$	—	$	—
Interest-bearing deposits in other banks	6,975		6,975		6,975		—		—
Investment securities	1,496,644		1,494,092		825		1,481,473		11,794
Loans held for sale	16,336		16,336		—		16,336		—
Net loans and leases	3,720,614		3,684,834		—		21,280		3,663,554
Mortgage servicing rights	15,843		17,161		—		—		17,161
Federal Home Loan Bank stock	7,761		N/A		N/A		N/A		N/A

Financial liabilities
Deposits:
Noninterest-bearing demand	1,395,556		1,395,556		1,395,556		—		—
Interest-bearing demand and savings and money market	2,414,930		2,414,930		2,414,930		—		—
Time	1,145,868		1,140,064		—		—		1,140,064
Short-term borrowings	32,000		32,000		—		32,000		—
Long-term debt	92,785		70,139		—		70,139		—



									Fair Value Measurement Using
(dollars in thousands)	Notional Amount		Carrying Amount			Estimated Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
December 31, 2017
Derivatives
Interest rate lock commitments	$	2,494	$	12		$	12		$	—	$	12		$	—
Forward sale commitments	18,748		(26		)	(26		)	—		(26		)	—

Off-balance sheet financial instruments
Commitments to extend credit	917,405		—			1,140			—		1,140			—
Standby letters of credit and financial guarantees written	13,551		—			203			—		203			—

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 and equity 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, mortgage servicing rights, and other real estate owned. These nonrecurring fair value adjustments typically involve application of the lower of cost or fair value accounting or write-downs of individual assets.

The Company's policy is to recognize transfers into or out of a level as of the end of the reporting period. 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, 2018. Also, there were no transfers of financial assets and liabilities into or out of Level 3 of the fair value hierarchy during the three and nine months ended September 30, 2018.

The following tables present the fair value of assets and liabilities measured on a recurring basis as of September 30, 2018 and December 31, 2017:



			Fair Value at Reporting Date Using
(dollars in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2018
Available-for-sale securities
Debt securities:
States and political subdivisions	$	173,552	$	—	$	162,408	$	11,144
Corporate securities	65,133		—		65,133		—
U.S. Treasury obligations and direct obligations of U.S Government agencies	33,919		—		33,919		—
Mortgage-backed securities:
Residential - U.S. Government sponsored entities	734,357		—		734,357		—
Commercial - U.S. Government agencies and sponsored entities	51,205		—		51,205		—
Residential - Non-government agencies	41,370		—		41,370		—
Commercial - Non-government agencies	133,466		—		133,466		—
Total available-for-sale securities	1,233,002		—		1,221,858		11,144

Equity securities	885		885		—		—

Derivatives - Interest rate lock and forward sale commitments	63		—		63		—
Total	$	1,233,950	$	885	$	1,221,921	$	11,144



				Fair Value at Reporting Date Using
(dollars in thousands)	Fair Value			Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
December 31, 2017
Available-for-sale securities
Debt securities:
States and political subdivisions	$	179,781		$	—	$	167,987		$	11,794
Corporate securities	74,278			—		74,278			—
U.S. Treasury obligations and direct obligations of U.S Government agencies	25,510			—		25,510			—
Mortgage-backed securities:
Residential - U.S. Government sponsored entities	800,683			—		800,683			—
Commercial - U.S. Government agencies and sponsored entities	39,725			—		39,725			—
Residential - Non-government agencies	46,763			—		46,763			—
Commercial - Non-government agencies	137,326			—		137,326			—
Total available-for-sale securities	1,304,066			—		1,292,272			11,794

Equity securities	825			825		—			—

Derivatives - Interest rate lock and forward sale commitments	(14		)	—		(14		)	—
Total	$	1,304,877		$	825	$	1,292,258		$	11,794

For the nine months ended September 30, 2018 and 2017, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:



(dollars in thousands)	Available for Sale Debt Securities: States and Political Subdivisions
Balance at December 31, 2017	$	11,794
Principal payments received	(280		)
Unrealized net gain (loss) included in other comprehensive income	(370		)
Balance at September 30, 2018	$	11,144

Balance at December 31, 2016	$	12,196
Principal payments received	(268		)
Unrealized net gain (loss) included in other comprehensive income	170
Balance at September 30, 2017	$	12,098

Within the states and political subdivisions available-for-sale debt securities category, the Company holds four mortgage revenue bonds issued by the City & County of Honolulu with an aggregate fair value of $11.1 million and $12.1 million at September 30, 2018 and September 30, 2017, respectively. 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, 2018, the weighted average discount rate utilized was 5.28% compared to 4.50% at September 30, 2017 and 4.81% at December 31, 2017, 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.

The following table presents the fair value of assets measured on a nonrecurring basis and the level of valuation assumptions used to determine the respective fair values as of September 30, 2018 and December 31, 2017:



			Fair Value Measurements Using
(dollars in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2018
Impaired loans ⁽¹⁾	$	19,170	$	—	$	19,170	$	—
Mortgage servicing rights	18,315		—		—		18,315
Other real estate ⁽²⁾	414		—		414		—

December 31, 2017
Impaired loans ⁽¹⁾	$	21,280	$	—	$	21,280	$	—
Mortgage servicing rights	17,161		—		—		17,161
Other real estate ⁽²⁾	851		—		851		—


⁽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 fair value less costs to sell. Fair value is generally based upon independent market prices or appraised values of the collateral.

The significant unobservable inputs used in the fair value measurement of the Company's mortgage servicing rights are the weighted average discount rate and the forecasted constant prepayment rate. As of September 30, 2018, the weighted average discount rate and the forecasted constant prepayment rate utilized were 9.5% and 14.0%, respectively, compared to 9.5% and 16.5%, respectively, as of September 30, 2017 and 9.5% and 16.0%, respectively, as of December 31, 2017. Significant increases (decreases) in the weighted average discount rate and/or the forecasted constant prepayment rate could result in a significantly lower (higher) fair value measurement.