Fair Value of Assets and Liabilities

Fair Value Hierarchy

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction between market participants at the measurement date. GAAP established a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:


•	Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets. A quoted market price in an active market provides the most reliable evidence of fair value and is used to measure fair value whenever available. A contractually binding sales price also provides reliable evidence of fair value.


•	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, or inputs that require significant management judgment or estimation, some of which may be internally developed.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Investment securities available for sale and marketable securities: Fair values for 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.

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

Mortgage servicing rights: MSR do not trade in an active market with readily observable market data and as a result, the Company classifies the fair value of these assets as Level 3 measurement. 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.

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 Company 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 June 30, 2018, the Company 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 Company 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.

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:



	June 30, 2018				December 31, 2017
(In Thousands)	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Level 1 inputs:
Cash, due from banks and deposits in other banks		$36,130		$36,130		$77,841		$77,841
Investment securities available for sale	60,175		60,175		59,117		59,117
Marketable equity securities	6,006		6,006		—		—

Level 2 inputs:
Investment securities available for sale	203,949		203,949		253,633		253,633
Investment in Federal Home Loan Bank stock	2,104		2,104		2,115		2,115
Accrued interest receivable	4,489		4,489		4,385		4,385
Interest rate swaps	956		956		261		261

Level 3 inputs:
Loans and loans held for sale¹	1,022,008		995,564		999,445		1,001,346
Purchased receivables, net	20,323		20,323		22,231		22,231
Interest rate lock commitments	1,417		1,417		873		873
Mortgage servicing rights	8,733		8,733		7,305		7,305

Financial liabilities:
Level 2 inputs:
Deposits		$1,205,521		$1,204,467		$1,258,283		$1,257,670
Securities sold under repurchase agreements	27,695		27,695		27,746		27,746
Borrowings	7,312		7,023		7,362		7,308
Accrued interest payable	91		91		24		24
Interest rate swaps	151		151		77		77
Retail interest rate contracts	134		134		—		—
Level 3 inputs:
Junior subordinated debentures	10,310		10,202		10,310		9,856

¹Carrying amount is net of unearned income. In accordance with the prospective adoption of ASU 2016-01, the fair value of loans and loans held for sale as of June 30, 2018 was measured using an exit price notion. The fair value of loans as of December 31, 2017 was measured using an entry price notion.

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)
June 30, 2018
Assets:
Available for sale securities
U.S. Treasury and government sponsored entities		$208,692		$39,534		$169,158		$—
Municipal securities	11,935		—		11,935		—
Corporate bonds	37,490		20,641		16,849		—
Collateralized loan obligations	6,007		—		6,007		—
Total available for sale securities		$264,124		$60,175		$203,949		$—
Preferred stock		$6,006		$6,006		$—		$—
Total marketable equity securities		$6,006		$6,006		$—		$—
Interest rate swaps		$956		$—		$956		$—
Interest rate lock commitments	1,417		—		—		1,417
Mortgage servicing rights	8,733		—		—		8,733
Total other assets		$11,106		$—		$956		$10,150
Liabilities:
Interest rate swaps		$151		$—		$151		$—
Retail interest rate contracts	134		—		134		—
Total other liabilities		$285		$—		$285		$—
December 31, 2017
Assets:
Available for sale securities
U.S. Treasury and government sponsored entities		$249,461		$49,878		$199,583		$—
Municipal securities	14,421		—		14,421		—
Corporate bonds	37,132		3,508		33,624		—
Collateralized loan obligations	6,005		—		6,005		—
Total available for sale securities		$307,019		$53,386		$253,633		$—
Preferred stock		$5,731		$5,731		$—		$—
Total marketable securities		$5,731		$5,731		$—		$—
Interest rate swaps		$261		$—		$261		$—
Interest rate lock commitments	873		—		—		873
Mortgage servicing rights	7,305		—		—		7,305
Total other assets		$8,439		$—		$261		$8,178
Liabilities:
Interest rate swaps		$77		$—		$77		$—
Total other liabilities		$77		$—		$77		$—

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 three and six month periods ended June 30, 2018 and 2017:



(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
Three Months Ended June 30, 2018
Interest rate lock commitments		$1,323		($602	)		$5,800		($5,104	)		$1,417		$1,417
Mortgage servicing rights	8,039		(118		)	812		—			8,733		—
Total		$9,362		($720	)		$6,612		($5,104	)		$10,150		$1,417
Three Months Ended June 30, 2017
Interest rate lock commitments		$1,534		($102	)		$4,445		($4,540	)		$1,337		$1,337
Mortgage servicing rights	5,325		(48		)	551		—			5,828		—
Total		$6,859		($150	)		$4,996		($4,540	)		$7,165		$1,337



(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
Six Months Ended June 30, 2018
Interest rate lock commitments		$873		($1,002	)		$9,484		($7,938	)		$1,417		$1,417
Mortgage servicing rights	7,305		(144		)	1,572		—			8,733		—
Total		$8,178		($1,146	)		$11,056		($7,938	)		$10,150		$1,417
Six Months Ended June 30, 2017
Interest rate lock commitments		$1,137		($418	)		$7,501		($6,883	)		$1,337		$1,337
Mortgage servicing rights	4,157		234			1,437		—			5,828		—
Total		$5,294		($184	)		$8,938		($6,883	)		$7,165		$1,337

As of and for the periods ending June 30, 2018 and December 31, 2017, except for certain assets as shown in the following table, no impairment or valuation adjustment was recognized for assets recognized at fair value on a nonrecurring basis. 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)
June 30, 2018
Loans measured for impairment		$373		$—		$—		$373
Total		$373		$—		$—		$373
December 31, 2017
Loans measured for impairment		$7,988		$—		$—		$7,988
Other real estate owned	3,927		—		—		3,927
Other assets - equity method investment	2,292		—		—		2,292
Total		$14,207		$—		$—		$14,207

The following table presents the gains and (losses) resulting from nonrecurring fair value adjustments for the three and six month periods ended June 30, 2018 and 2017:



	Three Months Ended June 30,					Six Months Ended June 30,
(In Thousands)	2018		2017			2018		2017
Loans measured for impairment		$299		$600			$893		$220
Other real estate owned	—		(100		)	—		(266		)
Total loss from nonrecurring measurements		$299		$500			$893		($46	)

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 recurring and nonrecurring basis at June 30, 2018 and December 31, 2017:



Financial Instrument	Valuation Technique	Unobservable Input	Weighted Average Rate Range
June 30, 2018
Loans measured for impairment	In-house valuation of collateral	Discount rate	25% - 65%
Interest rate lock commitment	External pricing model	Pull through rate	92.22	%
Mortgage servicing rights	Discounted cash flow	Constant prepayment rate	7.66% - 9.79%
		Discount rate	9.87% - 11.00%
December 31, 2017
Loans measured for impairment	In-house valuation of collateral	Discount rate	32% - 40%
	Discounted cash flow	Discount rate	14	%
Other real estate owned	Fair value of collateral	Estimated capital costs to complete improvements	25% - 32%
Interest rate lock commitment	External pricing model	Pull through rate	93.05	%
Mortgage servicing rights	Discounted cash flow	Constant prepayment rate	8.94% - 11.34%
		Discount rate	9.42% - 10.05%