Edgar Filing: Hilltop Holdings Inc.

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 September 30, 2014

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)

Maryland		84-1477939
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

200 Crescent Court, Suite 1330
Dallas, TX		75201
(Address of principal executive offices)		(Zip Code)

(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.

Large accelerated filer x		Accelerated filer £

Non-accelerated filer £		Smaller reporting company £
(Do not check if a smaller reporting company)

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 November 5, 2014 was 90,181,888.

Table of Contents

HILLTOP HOLDINGS INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2014

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 (Loss)	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	51

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	92

Item 6.	Exhibits	92

Table of Contents

HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

	September 30,			December 31,
	2014			2013
	(Unaudited)
Assets
Cash and due from banks	$	635,933		$	713,099
Federal funds sold and securities purchased under agreements to resell Securities:	11,655			32,924
Trading, at fair value	66,102			58,846
Available for sale, at fair value (amortized cost of $1,152,117 and $1,256,862, respectively)	1,146,101			1,203,143
Held to maturity, at amortized cost (fair value of $119,901)	120,139			—
	1,332,342			1,261,989

Loans held for sale	1,272,813			1,089,039
Non-covered loans, net of unearned income	3,768,843			3,514,646
Allowance for non-covered loan losses	(39,027		)	(33,241		)
Non-covered loans, net	3,729,816			3,481,405

Covered loans, net of allowance of $3,761 and $1,061, respectively	747,514			1,005,308
Broker-dealer and clearing organization receivables	223,679			119,317
Insurance premiums receivable	27,155			25,597
Deferred policy acquisition costs	21,754			20,991
Premises and equipment, net	205,734			200,706
FDIC indemnification asset	149,788			188,291
Covered other real estate owned	126,798			142,833
Mortgage servicing rights	41,907			20,149
Other assets	339,197			279,745
Goodwill	251,808			251,808
Other intangible assets, net	62,509			70,921
Total assets	$	9,180,402		$	8,904,122

Liabilities and Stockholders’ Equity
Deposits:
Noninterest-bearing	$	1,988,066		$	1,773,749
Interest-bearing	4,248,216			4,949,169
Total deposits	6,236,282			6,722,918

Broker-dealer and clearing organization payables	243,835			129,678
Reserve for losses and loss adjustment expenses	32,460			27,468
Unearned insurance premiums	93,500			88,422
Short-term borrowings	845,984			342,087
Notes payable	55,684			56,327
Junior subordinated debentures	67,012			67,012
Other liabilities	181,901			158,288
Total liabilities	7,756,658			7,592,200
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 and 100,000,000 shares authorized; 90,179,596 and 90,175,688 shares issued and outstanding, respectively	902			902
Additional paid-in capital	1,390,830			1,388,641
Accumulated other comprehensive loss	(3,727		)	(34,863		)
Accumulated deficit	(79,098		)	(157,607		)
Total Hilltop stockholders’ equity	1,422,975			1,311,141
Noncontrolling interest	769			781
Total stockholders’ equity	1,423,744			1,311,922
Total liabilities and stockholders’ equity	$	9,180,402		$	8,904,122

See accompanying notes.

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2014		2013		2014		2013
Interest income:
Loans, including fees	$	80,719	$	68,585	$	252,667	$	198,684
Securities:
Taxable	7,688		7,202		22,894		19,594
Tax-exempt	1,150		1,052		3,579		3,588
Federal funds sold and securities purchased under agreements to resell	10		35		43		91
Interest-bearing deposits with banks	303		282		1,215		857
Other	3,347		2,546		9,055		7,660
Total interest income	93,217		79,702		289,453		230,474

Interest expense:
Deposits	4,117		3,685		10,972		10,541
Short-term borrowings	665		384		1,599		1,488
Notes payable	633		2,294		1,913		6,924
Junior subordinated debentures	594		591		1,765		1,811
Other	1,448		832		3,577		2,108
Total interest expense	7,457		7,786		19,826		22,872

Net interest income	85,760		71,916		269,627		207,602
Provision for loan losses	4,033		10,658		12,808		34,952
Net interest income after provision for loan losses	81,727		61,258		256,819		172,650

Noninterest income:
Net realized gains on securities	—		1,142		—		1,142
Net gains from sale of loans and other mortgage production income	108,621		105,337		293,786		375,464
Mortgage loan origination fees	17,593		22,091		46,920		63,679
Net insurance premiums earned	41,821		39,982		122,917		116,045
Investment and securities advisory fees and commissions	24,055		22,310		67,654		70,283
Bargain purchase gain	—		12,585		—		12,585
Other	20,045		11,648		54,239		28,408
Total noninterest income	212,135		215,095		585,516		667,606

Noninterest expense:
Employees’ compensation and benefits	126,406		119,176		357,280		368,081
Loss and loss adjustment expenses	22,629		24,631		76,241		93,976
Policy acquisition and other underwriting expenses	11,571		11,739		34,910		34,169
Occupancy and equipment, net	25,345		20,974		77,445		60,540
Other	68,793		40,072		172,709		135,217
Total noninterest expense	254,744		216,592		718,585		691,983

Income before income taxes	39,118		59,761		123,750		148,273
Income tax expense	14,010		20,115		44,658		52,594

Net income	25,108		39,646		79,092		95,679
Less: Net income attributable to noncontrolling interest	296		339		583		1,207

Income attributable to Hilltop	24,812		39,307		78,509		94,472
Dividends on preferred stock	1,426		1,133		4,278		2,985
Income applicable to Hilltop common stockholders	$	23,386	$	38,174	$	74,231	$	91,487

Earnings per common share:
Basic	$	0.26	$	0.45	$	0.82	$	1.09
Diluted	$	0.26	$	0.43	$	0.82	$	1.05

Weighted average share information:
Basic	89,711		83,493		89,709		83,490
Diluted	90,558		90,460		90,570		90,251

See accompanying notes.

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(Unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2014			2013		2014		2013
Net income	$	25,108		$	39,646	$	79,092	$	95,679
Other comprehensive income (loss):
Unrealized gains (losses) on securities available for sale, net of tax of $(656), $1,135, $16,565 and $(13,641), respectively	(1,226		)	2,109		31,136		(25,332		)
Comprehensive income	23,882			41,755		110,228		70,347
Less: comprehensive income attributable to noncontrolling interest	296			339		583		1,207

Comprehensive income applicable to Hilltop	$	23,586		$	41,416	$	109,645	$	69,140

See accompanying notes.

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

(Unaudited)

											Accumulated						Total
								Additional			Other						Hilltop						Total
	Preferred Stock			Common Stock				Paid-in			Comprehensive			Accumulated			Stockholders’			Noncontrolling			Stockholders’
	Shares	Amount		Shares		Amount		Capital			Income (Loss)			Deficit			Equity			Interest			Equity
Balance, December 31, 2012	114	$	114,068	83,487		$	835	$	1,304,448		$	8,094		$	(282,949	)	$	1,144,496		$	2,054		$	1,146,550
Net income	—	—		—		—		—			—			94,472			94,472			1,207			95,679
Other comprehensive loss	—	—		—		—		—			(25,332		)	—			(25,332		)	—			(25,332		)
Stock-based compensation expense	—	—		—		—		1,071			—			—			1,071			—			1,071
Common stock issued to board members	—	—		7		—		96			—			—			96			—			96
Issuance of restricted common stock	—	—		465		5		(5		)	—			—			—			—			—
Dividends on preferred stock	—	—		—		—		(2,985		)	—			—			(2,985		)	—			(2,985		)
Cash distributions to noncontrolling interest	—	—		—		—		—			—			—			—			(2,383		)	(2,383		)
Balance, September 30, 2013	114	$	114,068	83,959		$	840	$	1,302,625		$	(17,238	)	$	(188,477	)	$	1,211,818		$	878		$	1,212,696

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	—	—		—		—		—			—			78,509			78,509			583			79,092
Other comprehensive income	—	—		—		—		—			31,136			—			31,136			—			31,136
Stock-based compensation expense	—	—		—		—		3,316			—			—			3,316			—			3,316
Common stock issued to board members	—	—		7		—		162			—			—			162			—			162
Forfeiture of restricted common stock awards	—	—		(3	)	—		(12		)	—			—			(12		)	—			(12		)
Dividends on preferred stock	—	—		—		—		(4,278		)	—			—			(4,278		)	—			(4,278		)
Issuance of common stock	—	—		—		—		3,001			—			—			3,001			—			3,001
Cash distributions to noncontrolling interest	—	—		—		—		—			—			—			—			(595		)	(595		)
Balance, September 30, 2014	114	$	114,068	90,180		$	902	$	1,390,830		$	(3,727	)	$	(79,098	)	$	1,422,975		$	769		$	1,423,744

See accompanying notes.

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HILLTOP HOLDINGS INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

	Nine Months Ended September 30,
	2014			2013
Operating Activities
Net income	$	79,092		$	95,679
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for loan losses	12,808			34,952
Depreciation, amortization and accretion, net	(63,367		)	(24,788		)
Net realized gains on securities	—			(1,142		)
Bargain purchase gain	—			(12,585		)
Deferred income taxes	6,418			(11,423		)
Other, net	16,669			3,914
Net change in trading securities	(7,256		)	46,859
Net change in broker-dealer and clearing organization receivables	(164,497		)	2,796
Net change in other assets	(40,193		)	22,851
Net change in broker-dealer and clearing organization payables	261,206			(37,386		)
Net change in loss and loss adjustment expense reserve	4,992			(2,745		)
Net change in unearned insurance premiums	5,078			9,466
Net change in other liabilities	20,233			(18,510		)
Net gains from sale of loans	(293,786		)	(375,464		)
Loans originated for sale	(7,954,706		)	(9,427,627		)
Proceeds from loans sold	8,067,301			10,157,410
Net cash provided by (used in) operating activities	(50,008		)	462,257

Investing Activities
Proceeds from maturities and principal reductions of securities held to maturity	2,821			—
Proceeds from sales, maturities and principal reductions of securities available for sale	152,537			211,732
Purchases of securities held to maturity	(123,021		)	—
Purchases of securities available for sale	(48,730		)	(255,142		)
Net change in loans	106,335			(48,859		)
Purchases of premises and equipment and other assets	(32,581		)	(20,264		)
Proceeds from sales of premises and equipment and other real estate owned	55,097			7,641
Net cash paid (received) for Federal Home Loan Bank and Federal Reserve Bank stock	(28,383		)	89
Net cash from FNB Transaction	—			362,695
Net cash provided by investing activities	84,075			257,892

Financing Activities
Net change in deposits	(633,685		)	(1,476		)
Net change in short-term borrowings	503,897			(422,953		)
Proceeds from notes payable	2,000			1,000
Payments on notes payable	(2,643		)	(2,428		)
Dividends paid on preferred stock	(4,194		)	(1,852		)
Net cash distributed to noncontrolling interest	(595		)	(2,383		)
Other, net	2,718			(243		)
Net cash used in financing activities	(132,502		)	(430,335		)

Net change in cash and cash equivalents	(98,435		)	289,814
Cash and cash equivalents, beginning of period	746,023			726,460
Cash and cash equivalents, end of period	$	647,588		$	1,016,274

Supplemental Disclosures of Cash Flow Information
Cash paid for interest	$	20,935		$	22,513
Cash paid for income taxes, net of refunds	$	19,893		$	52,752
Supplemental Schedule of Non-Cash Activities
Conversion of loans to other real estate owned	$	44,815		$	6,019

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. On November 30, 2012, Hilltop acquired PlainsCapital Corporation pursuant to a plan of merger whereby PlainsCapital Corporation merged with and into a wholly owned subsidiary of Hilltop (the “PlainsCapital Merger”), which continued as the surviving entity under the name “PlainsCapital Corporation” (“PlainsCapital”).

The Company has two primary operating business units, PlainsCapital and National Lloyds Corporation (“NLC”). PlainsCapital is a financial holding company, headquartered in Dallas, Texas, that provides, through its subsidiaries, an array of financial products and services. In addition to traditional banking services, PlainsCapital provides residential mortgage lending, investment banking, public finance advisory, wealth and investment management, treasury management, capital equipment leasing, fixed income sales, asset management, and correspondent clearing services. NLC is a property and casualty insurance holding company 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 September 13, 2013 (the “Bank Closing Date”), PlainsCapital Bank (the “Bank”) assumed substantially all of the liabilities, including all of the deposits, and acquired substantially all of the assets of Edinburg, Texas-based First National Bank (“FNB”) from the Federal Deposit Insurance Corporation (the “FDIC”), as receiver, and reopened former FNB branches acquired from the FDIC under the “PlainsCapital Bank” name (the “FNB Transaction”). Pursuant to the Purchase and Assumption Agreement (the “P&A Agreement”), the Bank and the FDIC entered into loss-share agreements whereby the FDIC agreed to share in the losses of certain covered loans and covered other real estate owned (“OREO”) that the Bank acquired, as further described in Note 2 to the consolidated financial statements. The fair value of the assets acquired was $2.2 billion, including $1.1 billion in covered loans, $286.2 million in securities, $135.2 million in covered OREO and $42.9 million in non-covered loans. The Bank also assumed $2.2 billion in liabilities, consisting primarily of deposits. The acquisition of FNB’s expansive branch network allowed the Bank to increase its presence in Texas to include the Rio Grande Valley, Houston, Corpus Christi, Laredo and El Paso markets, among others.

On March 31, 2014, the Company entered into a definitive merger agreement with SWS Group, Inc. (“SWS”) providing for the merger of SWS with and into Peruna LLC, a wholly owned subsidiary of Hilltop formed for the purpose of facilitating this transaction. SWS stockholders will receive per share consideration of 0.2496 shares of Hilltop common stock and $1.94 of cash, equating to $6.94 per share based on Hilltop’s closing price on September 30, 2014. The value of the merger consideration will fluctuate with the market price of Hilltop common stock. The Company intends to fund the cash portion of the consideration through available cash. The merger is subject to customary closing conditions, including regulatory approvals and approval of the stockholders of SWS, and is expected to be completed prior to the end of 2014.

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, 2013. 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

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

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 financial instruments, the amounts receivable under the loss-share agreements with 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.

Certain reclassifications have been made to the prior period consolidated financial statements to conform with the current period presentation.

Management made significant estimates and exercised significant judgment in estimating fair values and accounting associated with the FNB Transaction during the third quarter of 2013 due to the short time period between the Bank Closing Date and September 30, 2013. The Bank Closing Date valuations related to loans, FDIC Indemnification Asset, covered OREO, other intangible assets, assumed liabilities and taxes were considered preliminary at September 30, 2013. The operations of FNB were included in the Company’s operating results beginning September 14, 2013 and such operations included a preliminary bargain purchase gain of $3.3 million, before income taxes of $1.2 million, as disclosed in the Company’s Quarterly Report on Form 10-Q filed with the SEC on November 12, 2013.

During the quarter ended December 31, 2013, the estimated fair values of certain identifiable assets acquired and liabilities assumed as of the Bank Closing Date were adjusted in accordance with the Business Combinations Topic of the Accounting Standards Codification (“ASC”) as a result of additional information obtained about the facts and circumstances that existed as of the Bank Closing Date primarily related to the fair values of loans, covered OREO, FDIC Indemnification Asset, premises and equipment and other intangible assets. These adjustments resulted in an increase in the preliminary bargain purchase gain associated with the FNB Transaction to $12.6 million, before income taxes of $4.5 million. This change is reflected in the revised consolidated statements of operations within noninterest income during the three and nine months ended September 30, 2013. In the aggregate, the adjustments to the preliminary bargain purchase gain and related revisions to the accretion of discount on loans and other items increased net income for the three and nine months ended September 30, 2013 by $6.3 million as compared with amounts previously reported in the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013. Additionally, certain amounts previously reported in the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 within the consolidated balance sheet as of September 30, 2013, the related statements of comprehensive income (loss), stockholders’ equity and cash flows for the three and nine months ended September 30, 2013, as well as the notes to the consolidated financial statements, have been revised accordingly.

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. The Bank has a 100% membership interest in First Southwest Holdings, LLC (“First Southwest”) and PlainsCapital Securities, LLC.

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

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

The principal subsidiaries of First Southwest are First Southwest Company (“FSC”), a broker-dealer registered with the SEC and the Financial Industry Regulatory Authority and a member of the New York Stock Exchange, and First Southwest Asset Management, Inc., a registered investment advisor under the Investment Advisors Act of 1940.

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

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”) 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. Acquisitions

FNB Transaction

On the Bank Closing Date, the Bank assumed substantially all of the liabilities, including all of the deposits, and acquired substantially all of the assets of FNB from the FDIC in an FDIC-assisted transaction. As part of the P&A Agreement, the Bank and the FDIC entered into loss-share agreements covering future losses incurred on certain acquired loans and OREO. The Company refers to acquired commercial and single family residential loan portfolios and OREO that are subject to the loss-share agreements as “covered loans” and “covered OREO”, respectively, and these assets are presented as separate line items in the Company’s consolidated balance sheet. Collectively, covered loans and covered OREO are referred to as “covered assets”.

In accordance with the loss-share agreements, the Bank may be required to make a “true-up” payment to the FDIC approximately ten years following the Bank Closing Date if the FDIC’s initial estimate of losses on covered assets is greater than the actual realized losses. The “true-up” payment is calculated using a defined formula set forth in the P&A Agreement.

The FNB Transaction was accounted for using the purchase method of accounting and, accordingly, purchased assets, including identifiable intangible assets and assumed liabilities, were recorded at their respective fair values as of the Bank Closing Date using significant estimates and assumptions to value certain identifiable assets acquired and liabilities assumed. The amounts are subject to adjustments based upon final settlement with the FDIC. The terms of the P&A Agreement provide for the FDIC to indemnify the Bank against claims with respect to liabilities and assets of FNB or any of its affiliates not assumed or otherwise purchased by the Bank and with respect to certain other claims by third parties.

Pro Forma Results of Operations

The operations acquired in the FNB Transaction are included in the Company’s operating results beginning September 14, 2013. The purchase of assets and assumption of certain liabilities of FNB from the FDIC, as receiver, was sufficiently significant to require disclosure of historical financial statements and related pro forma financial disclosure. Due to the nature and magnitude of the FNB Transaction, coupled with the federal assistance and protection resulting from the FDIC loss-share agreements, historical financial information of FNB is not relevant to future operations. The Company has omitted certain historical financial information and the related pro forma financial information of FNB pursuant to the guidance provided in Staff Accounting Bulletin Topic 1.K, Financial Statements of Acquired Troubled Financial Institutions (“SAB 1:K”), and a request for relief granted by the SEC. SAB 1:K provides relief from the requirements of Rule 3-05 of Regulation S-X in certain instances, such as the FNB Transaction, where a registrant engages in an acquisition of a significant amount of assets of a troubled financial institution for which audited financial statements are not reasonably available and in which federal assistance is so persuasive as to substantially reduce the relevance of such information to an assessment of future operations.

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

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.

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”) 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. The Company determines the fair value of the financial instruments accounted for under the provisions of the Fair Value Option in compliance with the provisions of the Fair Value Topic of the ASC discussed above.

At September 30, 2014, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.25 billion, and the unpaid principal balance of those loans was $1.20 billion. At December 31, 2013, the aggregate fair value of PrimeLending’s mortgage loans held for sale accounted for under the Fair Value Option was $1.09 billion, and the unpaid principal balance of those loans was $1.07 billion. The interest component of fair value is reported as interest income on loans in the accompanying consolidated statements of operations.

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.

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

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
September 30, 2014	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	36	$	66,066	$	—	$	66,102
Available for sale securities	23,983		1,060,835		61,283		1,146,101
Loans held for sale	—		1,235,870		13,763		1,249,633
Derivative assets	—		25,268		—		25,268
Mortgage servicing rights asset	—		—		41,907		41,907
Trading liabilities	—		47		—		47
Derivative liabilities	—		3,718		6,827		10,545

	Level 1		Level 2		Level 3		Total
December 31, 2013	Inputs		Inputs		Inputs		Fair Value
Trading securities	$	33	$	58,813	$	—	$	58,846
Available for sale securities	22,079		1,121,011		60,053		1,203,143
Loans held for sale	—		1,061,310		27,729		1,089,039
Derivative assets	—		23,564		—		23,564
Mortgage servicing rights asset	—		—		20,149		20,149
Trading liabilities	—		46		—		46
Derivative liabilities	—		139		5,600		5,739

The following tables include a roll forward 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 September 30, 2014
Available for sale securities	$	63,819		$	—		$	—		$	639		$	(3,175	)	$	61,283
Loans held for sale	10,409			6,110			(1,600		)	(1,156		)	—			13,763
Mortgage servicing rights asset	35,877			18,982			(11,387		)	(1,565		)	—			41,907
Derivative liabilities	(6,300		)	(177		)	—			(350		)	—			(6,827		)
Total	$	103,805		$	24,915		$	(12,987	)	$	(2,432	)	$	(3,175	)	$	110,126

Nine months ended September 30, 2014
Available for sale securities	$	60,053		$	—		$	—		$	1,848		$	(618	)	$	61,283
Loans held for sale	27,729			16,531			(31,203		)	706			—			13,763
Mortgage servicing rights asset	20,149			33,790			(11,387		)	(645		)	—			41,907
Derivative liabilities	(5,600		)	(177		)	—			(1,050		)	—			(6,827		)
Total	$	102,331		$	50,144		$	(42,590	)	$	859		$	(618	)	$	110,126

Three months ended September 30, 2013
Available for sale securities	$	55,510		$	—		$	—		$	551		$	3,541		$	59,602
Mortgage servicing rights asset	7,111			4,079			—			2,211			—			13,401
Derivative liabilities	(4,939		)	—			—			(225		)	—			(5,164		)
Total	$	57,682		$	4,079		$	—		$	2,537		$	3,541		$	67,839

Nine months ended September 30, 2013
Available for sale securities	$	56,277		$	—		$	—		$	1,594		$	1,731		$	59,602
Mortgage servicing rights asset	2,080			8,384			—			2,937			—			13,401
Derivative liabilities	(4,490		)	—			—			(674		)	—			(5,164		)
Total	$	53,867		$	8,384		$	—		$	3,857		$	1,731		$	67,839

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

All net realized and unrealized gains (losses) in the tables above are reflected in the accompanying consolidated financial statements. The unrealized gains (losses) relate to financial instruments still held at September 30, 2014. The available for sale securities noted in the table above reflect Hilltop’s note receivable and SWS Warrant (defined hereinafter) as discussed in Note 4 to the consolidated financial statements.

For Level 3 financial instruments measured at fair value on a recurring basis at September 30, 2014, the significant unobservable inputs used in the fair value measurements were as follows.

			Weighted
Financial instrument	Valuation Technique	Unobservable Input	Average / Range
Available for sale securities - note receivable	Discounted cash flow	Discount rate	8.45%

Available for sale securities - warrant	Binomial model	SWS common stock price volatility	29.0%

Loans held for sale	Discounted cash flow / Market comparable	Projected price	89 - 91%

Mortgage servicing rights asset	Discounted cash flow	Constant prepayment rate	9.51%
		Discount rate	11.03%

Derivative liabilities	Discounted cash flow	Discount rate	14 - 28%
		Time to receive full payment of cash flows	10.5 - 13.75 years

Hilltop’s note receivable is valued using a cash flow model that estimates yield based on comparable securities in the market. The interest rate used to discount cash flows is the most significant unobservable input. An increase or decrease in the discount rate would result in a corresponding decrease or increase, respectively, in the fair value measurement of the note receivable.

The SWS Warrant is valued utilizing a binomial model. The underlying SWS common stock price and its related volatility, an unobservable input, are the most significant inputs into the model, and, therefore, decreases or increases to the SWS common stock price would result in a significant change in the fair value measurement of the SWS Warrant.

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.

The MSR asset is valued by projecting net servicing cash flows, which are then discounted to estimate the fair value. The fair value of the MSR asset is impacted by a variety of factors. Prepayment rates and discount rates, the most significant unobservable inputs, are discussed further in Note 7 to the consolidated financial statements.

Derivative liabilities in the tables above include a derivative option agreement (“Fee Award Option”) entered into by First Southwest and valued using discounted cash flows and probability of exercise.

The Company had no transfers between Levels 1 and 2 during the periods presented.

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

The following tables present the changes in fair value for instruments that are reported at fair value under the Fair Value Option (in thousands).

	Changes in Fair Value for Assets and Liabilities Reported at Fair Value under Fair Value Option
	Three Months Ended September 30, 2014								Three Months Ended September 30, 2013
				Other		Total					Other		Total
	Net			Noninterest		Changes in			Net		Noninterest		Changes in
	Gains (Losses)			Income		Fair Value			Gains (Losses)		Income		Fair Value
Loans held for sale	$	(15,250	)	$	—	$	(15,250	)	$	44,395	$	—	$	44,395
Mortgage servicing rights asset	(1,565		)	—		(1,565		)	2,211		—		2,211
Time deposits	—			—		—			—		—		—

	Changes in Fair Value for Assets and Liabilities Reported at Fair Value under Fair Value Option
	Nine Months Ended September 30, 2014								Nine Months Ended September 30, 2013
				Other		Total					Other		Total
	Net			Noninterest		Changes in			Net		Noninterest		Changes in
	Gains (Losses)			Income		Fair Value			Gains (Losses)		Income		Fair Value
Loans held for sale	$	24,918		$	—	$	24,918		$	2,754	$	—	$	2,754
Mortgage servicing asset	(645		)	—		(645		)	2,937		—		2,937
Time deposits	—			—		—			—		12		12

The Company also determines the fair value of certain assets and liabilities on a non-recurring basis. In addition, facts and circumstances may dictate a fair value measurement when there is evidence of impairment. Assets and liabilities measured on a non-recurring basis include the items discussed below.

Impaired Loans — The Company reports impaired loans based on the underlying fair value of the collateral through specific allowances within the allowance for loan losses. Purchased credit impaired (“PCI”) loans with a fair value of $172.9 million and $822.8 million were acquired by the Company upon completion of the PlainsCapital Merger and the FNB Transaction, respectively. Substantially all PCI loans acquired in the FNB Transaction are covered by FDIC loss-share agreements. The fair value of PCI loans was determined using Level 3 inputs, including estimates of expected cash flows that incorporated significant unobservable inputs regarding default rates, loss severity rates assuming default, prepayment speeds and estimated collateral values. At September 30, 2014, these inputs included estimated weighted average default rates, loss severity rates and prepayment speed assumptions of 46%, 52% and 0%, respectively, for those PCI loans acquired in the PlainsCapital Merger and 63%, 38% and 4%, respectively, for those PCI loans acquired in the FNB Transaction. The resulting weighted average expected loss on PCI loans associated with each of the PlainsCapital Merger and the FNB Transaction was 24%.

The Company obtains updated appraisals of the fair value of collateral securing impaired collateral dependent loans at least annually, in accordance with regulatory guidelines. The Company also reviews the fair value of such collateral on a quarterly basis. If the quarterly review indicates that the fair value of the collateral may have deteriorated, the Company will order an updated appraisal of the fair value of the collateral. Since the Company obtains updated appraisals when evidence of a decline in the fair value of collateral exists, it typically does not adjust appraised values.

Other Real Estate Owned — The Company reports OREO at fair value less estimated cost to sell. Any excess of recorded investment over fair value, less cost to sell, is charged against either the allowance for loan losses or the related PCI pool discount when property is initially transferred to OREO. Subsequent to the initial transfer to OREO, downward valuation adjustments are charged against earnings. The Company determines fair value primarily using independent appraisals of OREO properties. The resulting fair value measurements are classified as Level 2 or Level 3 inputs, depending upon the extent to which unobservable inputs determine the fair value measurement. The Company considers a number of factors in determining the extent to which specific fair value measurements utilize unobservable inputs, including, but not limited to, the inherent subjectivity in appraisals, the length of time elapsed since the receipt of independent market price or appraised value, and current market conditions. At September 30, 2014, the most significant unobservable input used in the determination of fair value of OREO was a discount to independent appraisals for estimated holding periods of OREO properties. Such discount was 1% per month for estimated holding periods of 6 to 24 months. Level 3 inputs were used to determine the fair value of a large group of smaller balance properties that were acquired in the FNB Transaction. In the FNB Transaction, the Bank acquired OREO of $135.2 million, all of which is covered by FDIC loss-share agreements. At

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

September 30, 2014 and December 31, 2013, the estimated fair value of covered OREO was $126.8 million and $142.8 million, respectively, and the underlying fair value measurements utilize Level 2 and Level 3 inputs. The fair value of non-covered OREO at September 30, 2014 and December 31, 2013 was $2.3 million and $4.8 million, respectively, and is included in other assets within the consolidated balance sheets. During the reported periods, all fair value measurements for non-covered OREO utilized Level 2 inputs.

The following table presents information regarding certain assets and liabilities measured at fair value on a non-recurring basis for which a change in fair value has been recorded during reporting periods subsequent to initial recognition (in thousands).

									Total Gains (Losses) for the						Total Gains (Losses) for the
	Level 1		Level 2		Level 3		Total		Three Months Ended September 30,						Nine Months Ended September 30,
September 30, 2014	Inputs		Inputs		Inputs		Fair Value		2014			2013			2014			2013
Non-covered impaired loans	$	—	$	—	$	30,061	$	30,061	$	(1,714	)	$	(2,352	)	$	(2,151	)	$	(3,011	)
Covered impaired loans	—		—		74,015		74,015		242			—			(2,790		)	—
Non-covered other real estate owned	—		—		—		—		(210		)	(1,381		)	(321		)	(1,571		)
Covered other real estate owned	—		45,050		20,803		65,853		(14,440		)	—			(17,399		)	—

The Fair Value of Financial Instruments Subsection of the ASC requires disclosure of the fair value of financial assets and liabilities, including the financial assets and liabilities previously discussed. The methods for determining estimated fair value for financial assets and liabilities is described in detail in Note 3 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2013.

The following tables present the carrying values and estimated fair values of financial instruments not measured at fair value on either a recurring or non-recurring basis (in thousands).

			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
September 30, 2014	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	647,588	$	647,588	$	—	$	—	$	647,588
Held to maturity securities	120,139		—		119,901		—		119,901
Loans held for sale	23,180		—		23,180		—		23,180
Non-covered loans, net	3,729,816		—		341,846		3,406,917		3,748,763
Covered loans, net	747,514		—		—		823,111		823,111
Broker-dealer and clearing organization receivables	223,679		—		223,679		—		223,679
FDIC indemnification asset	149,788		—		—		149,788		149,788
Other assets	63,925		—		42,301		21,624		63,925

Financial liabilities:
Deposits	6,236,282		—		6,238,982		—		6,238,982
Broker-dealer and clearing organization payables	243,835		—		243,835		—		243,835
Short-term borrowings	845,984		—		845,984		—		845,984
Debt	122,696		—		116,007		—		116,007
Other liabilities	2,251		—		2,251		—		2,251

			Estimated Fair Value
	Carrying		Level 1		Level 2		Level 3
December 31, 2013	Amount		Inputs		Inputs		Inputs		Total
Financial assets:
Cash and cash equivalents	$	746,023	$	746,023	$	—	$	—	$	746,023
Non-covered loans, net	3,481,405		—		281,712		3,119,319		3,401,031
Covered loans, net	1,005,308		—		—		997,371		997,371
Broker-dealer and clearing organization receivables	119,317		—		119,317		—		119,317
FDIC indemnification asset	188,291		—		—		188,291		188,291
Other assets	66,055		—		43,946		22,109		66,055

Financial liabilities:
Deposits	6,722,019		—		6,722,909		—		6,722,909
Broker-dealer and clearing organization payables	129,678		—		129,678		—		129,678
Short-term borrowings	342,087		—		342,087		—		342,087
Debt	123,339		—		114,671		—		114,671
Other liabilities	3,362		—		3,362		—		3,362

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Hilltop Holdings Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

(Unaudited)

4. Securities

The amortized cost and fair value of securities, excluding trading securities, are summarized as follows (in thousands). No securities were classified as held to maturity at December 31, 2013.

	Available for Sale
			Gross		Gross
	Amortized		Unrealized		Unrealized
September 30, 2014	Cost		Gains		Losses			Fair Value
U.S. Treasury securities	$	44,709	$	149	$	(64	)	$	44,794
U.S. government agencies:
Bonds	637,882		1,397		(18,522		)	620,757
Residential mortgage-backed securities	53,780		1,626		(401		)	55,005
Collateralized mortgage obligations	100,938		137		(4,093		)	96,982
Corporate debt securities	95,251		4,795		(128		)	99,918
States and political subdivisions	141,813		1,917		(1,007		)	142,723
Commercial mortgage-backed securities	596		60		—			656
Equity securities	20,558		3,425		—			23,983
Note receivable	44,522		5,327		—			49,849
Warrant	12,068		—		(634		)	11,434
Totals	$	1,152,117	$	18,833	$	(24,849	)	$	1,146,101

	Available for Sale
	Amortized		Unrealized		Unrealized
December 31, 2013	Cost		Gains		Losses			Fair Value
U.S. Treasury securities	$	43,684	$	82	$	(238	)	$	43,528
U.S. government agencies:
Bonds	717,909		550		(55,727		)	662,732