Fair Value Measurements

The Company groups its assets and liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:


•	Level 1: Valuation is based upon quoted prices for identical instruments traded in active exchange markets, such as the New York Stock Exchange. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.


•	Level 2: Valuation is based upon quoted market 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 the Company’s estimation of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following methods and assumptions were used to estimate fair value disclosures. All financial instruments are held for other than trading purposes.

Cash and cash equivalents: Due to the short term nature of these instruments, the carrying amounts reported in the balance sheet represent their fair values.

Investment securities: Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Investments in Federal Home Loan Bank stock are recorded at cost, which also represents fair value.

Loans held for sale: Due to the short term nature of these instruments, the carrying amounts reported in the balance sheet represent their fair values.

Loans: Fair values were generally determined by discounting both principal and interest cash flows on pools of loans expected to be collected using a discount rate for similar instruments with adjustments that the Company believes a market participant would consider in determining fair value. The Company estimates the cash flows expected to be collected using internal credit risk, interest rate and prepayment risk models that incorporate the Corporation’s best estimate of current key assumptions, such as default rates, loss severity and prepayment speeds for the life of the loan. The carrying value of loans is presented net of the Allowance (see Note 7). Impaired loans are carried at fair value. Specific valuation allowances are included in the Allowance.

Purchased receivables: Fair values for purchased receivables are based on their carrying amounts due to their short duration and repricing frequency. Generally, purchased receivables have a duration of less than one year.

Mortgage servicing rights: MSR are measured at fair value on a recurring basis. These assets are classified as Level 3 as quoted

prices are not available. In order to determine the fair value of MSRs, the present value of net expected future cash flows is estimated. Assumptions used include market discount rates, anticipated prepayment speeds, escrow calculations, delinquency rates, and ancillary fee income net of servicing costs. The model assumptions are also compared to publicly filed information from several large MSR holders, as available.

Accrued interest receivable: Due to the short term nature of these instruments, the carrying amounts reported in the balance sheet represent their fair values.

Deposits: The fair value for deposits with stated maturities was determined by discounting contractual cash flows using current market rates for instruments with similar maturities. For deposits with no stated maturities; the carrying value was considered to approximate fair value and does not take into account the significant value of the cost advantage and stability of the Company's long-term relationships with depositors.

Accrued interest payable: Due to the short term nature of these instruments, the carrying amounts reported in the balance sheet represent their fair values.

Securities sold under repurchase agreements: Fair values for securities sold under repurchase agreements are based on their carrying amounts due to their short duration and repricing frequency.

Borrowings: Due to the short term nature of these instruments, the carrying amount of short-term borrowings reported in the balance sheet approximate the fair value. Fair values for long-term borrowings are estimated using a discounted cash flow calculation that applies currently offered interest rates to a schedule of aggregate expected monthly payments.

Accrued liability, RML acquisition payments: The carrying value of the accrued liability for estimated acquisition payments represents management's estimate of amounts owed to the sellers that are earned, but unpaid, as of the balance sheet date. Adjustments to the liability are reported in other operating expense. The fair value for this liability represents management's estimate of the total amount owed to the sellers that is earned as of the balance sheet date plus management's estimate of amounts that will be earned and paid to the sellers under the terms of the acquisition RML agreement for future periods. The estimate is based on management's assessment of expected pre-tax income at RML over the remaining earn out period. Inputs to this assessment include the general economic conditions in our markets that impact mortgage loan originations, current and anticipated trends in local market demand for mortgage, including interest rates, and RML's estimated market share.

Junior subordinated debentures: Fair value adjustments for junior subordinated debentures are based on discounted cash flows to maturity using current interest rates for similar financial instruments. Management utilized a market approach to determine the appropriate discount rate for junior subordinated debentures.

Derivative Instruments: The fair value of the interest rate lock commitments are estimated using quoted or published market prices for similar instruments, adjusted for factors such as pull-through rate assumptions based on historical information, where appropriate. The pull-through rate assumptions are considered Level 3 valuation inputs and are significant to the interest rate lock commitment valuation; as such, the interest rate lock commitment derivatives are classified as Level 3. Interest rate contracts are valued in a model, which uses as its basis a discounted cash flow technique incorporating credit valuation adjustments to reflect nonperformance risk in the measurement of fair value. Although the Bank has determined that the majority of inputs used to value its interest rate derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of December 31, 2016, the Bank has assessed the significance of the impact of these adjustments on the overall valuation of its interest rate positions and has determined that they are not significant to the overall valuation of its interest rate derivatives. As a result, the Bank has classified its interest rate derivative valuations in Level 2 of the fair value hierarchy.

Assets subject to nonrecurring adjustment to fair value: The Company is also required to measure certain assets such as equity method investments, goodwill, intangible assets, impaired loans, and other real estate owned (“OREO”) at fair value on a nonrecurring basis in accordance with GAAP. Any nonrecurring adjustments to fair value usually result from the write down of individual assets.

The Company uses either in-house evaluations or external appraisals to estimate the fair value of OREO and impaired loans as of each reporting date. In-house appraisals are considered Level 3 inputs and external appraisals are considered Level 2 inputs. The Company’s determination of which method to use is based upon several factors. The Company takes into account compliance with legal and regulatory guidelines, the amount of the loan, the size of the assets, the location and type of property to be valued and how critical the timing of completion of the analysis is to the assessment of value. Those factors are balanced with the level of internal expertise, internal experience and market information available, versus external expertise available such as qualified appraisers, brokers, auctioneers and equipment specialists.

The Company uses external sources to estimate fair value for projects that are not fully constructed as of the date of valuation. These projects are generally valued as if complete, with an appropriate allowance for cost of completion, including contingencies developed from external sources such as vendors, engineers and contractors. The Company believes that recording other real estate owned that is not fully constructed based on as if complete values is more appropriate than recording other real estate owned that is not fully constructed using as is values. We concluded that as-is-complete values are appropriate for these types of projects based on the accounting guidance for capitalization of project costs and subsequent measurement of the value of real estate. GAAP specifically states that estimates and cost allocations must be reviewed at the end of each reporting period and reallocated based on revised estimates. The Company adjusts the carrying value of other real estate owned in accordance with this guidance for increases in estimated cost to complete that exceed the fair value of the real estate at the end of each reporting period.

Commitments to extend credit and standby letters of credit: The fair value of commitments is estimated using 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. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligation with the counterparties at the reporting date.

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 the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s 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.

Estimated fair values as of the periods indicated are as follows:



	December 31, 2016				December 31, 2015
(In Thousands)	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Level 1 inputs:
Cash, due from banks and deposits in other banks		$50,551		$50,551		$58,673		$58,673
Investment securities	43,486		43,486		43,033		43,033

Level 2 inputs:
Investment securities	288,632		288,655		248,983		249,039
Investment in Federal Home Loan Bank Stock	1,965		1,965		1,816		1,816
Accrued interest receivable	3,734		3,734		3,620		3,620
Commercial interest rate swaps	71		71		125		125

Level 3 inputs:
Loans and loans held for sale	1,018,611		1,026,350		1,031,340		1,033,551
Purchased receivables, net	20,491		20,491		13,326		13,326
Interest rate lock commitments	1,137		1,137		1,514		1,514
Mortgage servicing rights	4,157		4,157		1,654		1,654

Financial liabilities:
Level 2 inputs:
Deposits		$1,267,653		$1,266,995		$1,240,792		$1,240,223
Securities sold under repurchase agreements	27,607		27,607		31,420		31,420
Borrowings	4,338		4,186		2,120		2,101
Accrued interest payable	64		64		56		56
Commercial interest rate swaps	71		71		125		125
Retail interest rate contracts	78		78		91		91
Level 3 inputs:
Accrued liability, RML acquisition payments	186		4,500		6,624		6,624
Junior subordinated debentures	18,558		18,398		18,558		17,433

Unrecognized financial instruments:
Commitments to extend credit⁽¹⁾		$236,624		$2,366		$222,387		$2,224
Standby letters of credit⁽¹⁾	9,931		99		6,399		64

⁽¹⁾Carrying amounts reflect the notional amount of credit exposure under these financial instruments.

The following table sets forth the balances as of the periods indicated of assets measured at fair value on a recurring basis:



(In Thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
December 31, 2016
Assets:
Available for sale securities
U.S. Treasury and government sponsored entities		$263,361		$30,063		$233,298		$—
Municipal securities	18,157		—		18,157		—
U.S. Agency mortgage-backed securities	2		—		2		—
Corporate bonds	44,732		8,456		36,276		—
Preferred stock	4,967		4,967		—		—
Total available for sale securities		$331,219		$43,486		$287,733		$—
Commercial interest rate swaps		$71		$—		$71		$—
Interest rate lock commitments	1,137		—		—		1,137
Mortgage servicing rights	4,157		—		—		4,157
Total other assets		$5,365		$—		$71		$5,294
Liabilities:
Commercial interest rate swaps		$71		$—		$71		$—
Retail interest rate contracts	78		—		78		—
Total other liabilities		$149		$—		$149		$—
December 31, 2015
Assets:
Available for sale securities
U.S. Treasury and government sponsored entities		$237,436		$35,008		$202,428		$—
Municipal securities	10,326		—		10,326		—
U.S. Agency mortgage-backed securities	809		—		809		—
Corporate bonds	39,018		4,501		34,517		—
Preferred stock	3,524		3,524		—		—
Total available for sale securities		$291,113		$43,033		$248,080		$—
Commercial interest rate swaps	125		—		125		—
Interest rate lock commitments	1,514		—		—		1,514
Mortgage servicing rights	1,654		—		—		1,654
Total other assets		$3,293		$—		$125		$3,168
Liabilities:
Commercial interest rate swaps		$125		$—		$125		$—
Retail interest rate contracts	91		—		91		—
Total other liabilities		$216		$—		$216		$—

The following table provides a reconciliation of the assets and liabilities measured at fair value using significant unobservable inputs (Level 3) on a recurring basis during the years ended December 31, 2016 and 2015:



(In Thousands)	Beginning balance		Change included in earnings			Purchases and issuances		Sales and settlements			Ending balance		Net change in unrealized gains (losses) relating to items held at end of period
December 31, 2016
Interest rate lock commitments		$1,514		($2,063	)		$20,612		($18,926	)		$1,137		$1,137
Mortgage servicing rights	1,654		(526		)	3,029		—			4,157		—
Total		$3,168		($2,589	)		$23,641		($18,926	)		$5,294		$1,137
December 31, 2015
Interest rate lock commitments		$841		($2,270	)		$20,886		($17,943	)		$1,514		$1,514
Mortgage servicing rights	1,010		(158		)	802		—			1,654		—
Total		$1,851		($2,428	)		$21,688		($17,943	)		$3,168		$1,514

For 2016 and 2015, no impairment or valuation adjustment was recognized for assets recognized at fair value on a nonrecurring basis, except for certain assets as shown in the following table. For loans measured for impairment, the Company classifies fair value measurements using observable inputs, such as external appraisals, as Level 2 valuations in the fair value hierarchy, and unobservable inputs, such as in-house evaluations, as Level 3 valuations in the fair value hierarchy.



(In Thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total (gains) losses
December 31, 2016
Loans measured for impairment		$9,222		$—		$—		$9,222		$270
Other real estate owned	1,700		—		—		1,700		187
Total		$10,922		$—		$—		$10,922		$457
December 31, 2015
Loans measured for impairment		$1,061		$—		$—		$1,061		$269
Other real estate owned	830		—		—		830		361
Total		$1,891		$—		$—		$1,891		$630

Assets and Liabilities Measured at Fair Value Using Significant Unobservable Inputs (Level 3)

The following table provides a description of the valuation technique, unobservable input, and qualitative information about the unobservable inputs for the Company’s assets and liabilities classified as Level 3 and measured at fair value on a nonrecurring basis at December 31, 2016:



Financial Instrument	Valuation Technique	Unobservable Input	Weighted Average or Rate Range
Loans measured for impairment	In-house valuation of collateral	Discount rate	49% - 100%
	Discounted cash flow	Discount rate	7	%
Other real estate owned	Fair value of collateral	Estimated capital costs to complete improvements	11.50% - 25%
Interest rate lock commitment	External pricing model	Pull through rate	92.75	%
Mortgage servicing rights	Discounted cash flow	Constant prepayment rate	11.52% - 21.29%
		Discount rate	9.21% - 10.75%