Fair Value Measurements

FASB ASC 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820-10 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Transfers between levels of the fair value hierarchy are recognized on the actual dates of the event or circumstances that caused the transfer, which generally coincides with the Corporation’s monthly and or quarterly valuation process. The standard describes three levels of inputs that may be used to measure fair values:

Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 - Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Corporation used the following methods to determine the fair value of each type of financial instrument:

Investment securities: The fair values for investment securities are determined by quoted market prices for similar securities from active markets (Level 2) or by independent valuations (Level 3) for securities not traded in active markets.

Residential loans held for sale: The fair value of loans held for sale is determined using quoted prices for a similar asset, adjusted for specific attributes of that loan (Level 2).

Derivative financial instruments: Derivative instruments are used to hedge residential mortgage loans held for sale and the related interest-rate lock commitments and include forward commitments to sell mortgage loans and mortgage backed securities. The fair values of derivative financial instruments are based on derivative market data inputs as of the valuation date and the underlying value of mortgage loans for rate lock commitments (Level 3).

Impaired loans: The fair values of impaired loans are measured for impairment using the fair value of the collateral for collateral-dependent loans on a non-recurring basis. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The use of discounted cash flow models and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral (Level 3).

Other real estate owned: The fair value of other real estate owned, which is included in other assets on the balance sheet, consists of real estate that has been foreclosed. Foreclosed real estate is recorded at the lower of fair value less selling expenses or the book balance prior to foreclosure. Write downs are provided for subsequent declines in value and are recorded in other noninterest expense (Level 2).

Assets and liabilities measured at fair value under FASB ASC 820-10 on a recurring and non-recurring basis, including financial assets and liabilities for which the Corporation has elected the fair value option, are summarized below:



	Fair Value Measurement at December 31, 2017 Using
Description	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(In Thousands)
Financial Assets-Recurring
Available-for-sale investment securities
U.S. Treasury notes	$	50	$	50	$	—	$	—
US Government agency	5,065		—		5,065		—
Mortgage backed	260,455		—		260,455		—
Corporate bonds	4,482		—		4,482		—
Asset backed securities	33,600		—		29,321		4,279
Certificates of deposit	1,981		—		1,981		—
Municipals	100,434		—		100,434		—
CRA Mutual fund	1,379		—		1,379		—
Total available-for-sale investment securities	407,446		50		403,117		4,279
Residential loans held for sale	31,999		—		31,999		—
Derivative assets	420		—		—		420
Total Financial Assets-Recurring	$	439,865	$	50	$	435,116	$	4,699
Financial Liabilities-Recurring
Derivative liabilities	$	195	$	—	$	—	$	195
Total Financial Liabilities-Recurring	$	195	$	—	$	—	$	195
Financial Assets-Non-Recurring
Impaired loans (1)	$	4,626	$	—	$	—	$	4,626
Long-lived asset held for sale	643				—		643
Total Financial Assets-Non-Recurring	$	5,269	$	—	$	—	$	5,269

(1) Represents the carrying value of loans for which adjustments are based on the appraised value of the collateral, if collateral dependent, or the present value of expected future cash flows, discounted at the loan's effective interest rate.



	Fair Value Measurement at December 31, 2016 Using
Description	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	(In Thousands)
Financial Assets-Recurring
Available-for-sale investment securities
US Government agency	$	4,994	$	—	$	4,994	$	—
Mortgage backed	119,807		—		119,807		—
Corporate bonds	8,666		—		8,666		—
Asset backed securities	12,864		—		8,364		4,500
Certificates of deposit	2,009		—		2,009		—
Municipals - nontaxable	44,359		—		44,359		—
CRA Mutual fund	1,391		—		1,391		—
Total available-for-sale investment securities	194,090		—		189,590		4,500
Residential loans held for sale	35,676		—		35,676		—
Derivative assets	993		—		—		993
Total Financial Assets-Recurring	$	230,759	$	—	$	225,266	$	5,493
Financial Liabilities-Recurring
Derivative liabilities	$	325	$	—	$	—	$	325
Total Financial Liabilities-Recurring	$	325	$	—	$	—	$	325
Financial Assets-Non-Recurring
Impaired loans (1)	$	6,922	$	—	$	—	$	6,922
Total Financial Assets-Non-Recurring	$	6,922	$	—	$	—	$	6,922

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows for the twelve month period ended December 31, 2017 and 2016.



	Net Derivatives			Securities Available-For- Sale			Total
	(In Thousands)
Balance January 1, 2017	$	668		$	4,500		$	5,168
Realized and unrealized losses included in earnings	(486		)	—			(486		)
Unrealized gains (losses) included in other comprehensive income	43			(221		)	(178		)
Purchases, settlements, paydowns, and maturities	—			—			—
Transfer into Level 3	—			—			—
Balance December 31, 2017	$	225		$	4,279		$	4,504



	Net Derivatives		Securities Available-For- Sale		Total
	(In Thousands)
Balance January 1, 2016	$	273	$	—	$	273
Realized and unrealized gains included in earnings	395		—		395
Unrealized gains (losses) included in other comprehensive income	—		—		—
Purchases, settlements, paydowns, and maturities	—		—		—
Transfer into Level 3	—		4,500		4,500
Balance December 31, 2016	$	668	$	4,500	$	5,168

During the fourth quarter of 2016, management transferred two asset backed securities into Level 3 from Level 2 due to the lack of readily available pricing information on these particular securities. Pricing for these securities is now obtained through an independent valuation service.

The following table presents qualitative information about Level 3 fair value measurements for financial instruments measured at fair value at December 31, 2017 and 2016:



2017
Description	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range (Weighted Average)
	(In Thousands)
Financial Assets - Recurring
Asset-backed securities	$	4,279	Valuation service	Discounted cash flows	3% - 6% (5.0%)
Derivative assets	$	420	Market pricing (3)	Estimated pullthrough	75% - 90% (89.0%)
Derivative liabilities	$	195	Market pricing (3)	Estimated pullthrough	75% - 90% (89.0%)
Financial Assets - Non-recurring
Impaired loans - Real estate secured	$	2,736	Appraisal of collateral (1)	Liquidation expenses (2)	0% - 15% (10%)
Impaired loans - Non-real estate secured	$	1,890	Cash flow basis	Liquidation expenses (2)	0% - 10% (5%)


(1)	Fair value is generally determined through independent appraisals of the underlying collateral on real estate secured loans, which generally include various level 3 inputs which are not identifiable.


(2)	Valuations of impaired loans may be adjusted by management for qualitative factors such as liquidation expenses. The range and weighted average of liquidation expense adjustments are presented as a percent of the appraisal.


(3)	Market pricing on derivative assets and liabilities is adjusted by management for the anticipated percent of derivative assets and liabilities that will create a realized gain or loss. The range and weighted average of estimated pull-through is presented.



2016
Description	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range (Weighted Average)
	(In Thousands)
Financial Assets - Recurring
Asset-backed securities	$	4,500	Valuation service	Discounted cash flows	3% - 6% (5.0%)
Derivative assets	$	993	Market pricing (3)	Estimated pullthrough	75% - 90% (89.0%)
Derivative liabilities	$	325	Market pricing (3)	Estimated pullthrough	75% - 90% (89.0%)
Financial Assets - Non-recurring
Impaired loans - Real estate secured	$	1,371	Appraisal of collateral (1)	Liquidation expenses (2)	0% - 15% (10%)
Impaired loans - Non-real estate secured	$	5,551	Cash flow basis	Liquidation expenses (2)	0% - 10% (5%)


(1)	Fair value is generally determined through independent appraisals of the underlying collateral on real estate secured loans, which generally include various level 3 inputs which are not identifiable.


(2)	Valuations of impaired loans may be adjusted by management for qualitative factors such as liquidation expenses. The range and weighted average of liquidation expense adjustments are presented as a percent of the appraisal.


(3)	Market pricing on derivative assets and liabilities is adjusted by management for the anticipated percent of derivative assets and liabilities that will create a realized gain or loss. The range and weighted average of estimated pull-through is presented.

Financial instruments recorded using FASB ASC 825-10

Under FASB ASC 825-10, the Corporation may elect to report most financial instruments and certain other items at fair value on an instrument-by-instrument basis with changes in fair value reported in net income. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability or firm commitment or when certain specified reconsideration events occur. The fair value election, with respect to an item, may not be revoked once an election is made.

The following tables reflect the difference between the fair value carrying amount of residential mortgage loans held for sale, measured at fair value under FASB ASC 825-10, and the aggregate unpaid principal amount the Corporation is contractually entitled to receive at maturity.



	December 31, 2017
(In Thousands)	Aggregate Fair Value		Difference		Contractual Principal
Residential mortgage loans held for sale	$	31,999	$	1,102	$	30,897



	December 31, 2016
(In Thousands)	Aggregate Fair Value		Difference		Contractual Principal
Residential mortgage loans held for sale	$	35,676	$	1,004	$	34,672

The Corporation has elected to account for residential loans held for sale at fair value to eliminate the mismatch that would occur by recording changes in market value on derivative instruments used to hedge loans held for sale while carrying the loans at the lower of cost or market.

The following methods and assumptions not previously presented were used in estimating the fair value of financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis:

Cash and Short-Term Investments

For those short-term instruments, the carrying amount is a reasonable estimate of fair value. As such they are classified as Level 1 for noninterest-bearing deposits and Level 2 for interest-bearing deposits due from banks or federal funds sold.

Restricted Stock

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

Loans, Net of Allowance

For certain homogeneous categories of loans, such as some residential mortgages, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics resulting in a Level 3 classification. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities resulting in a Level 3 classification.

Deposits and Borrowings

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date resulting in a Level 1 classification. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities also resulting in a Level 1 classification. The fair value of all other deposits and borrowings is determined using the discounted cash flow method thereby resulting in a Level 2 classification. The discount rate was equal to the rate currently offered on similar products.

Accrued Interest

The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification depending upon the level of the asset or liability, with which, the accrual is associated.

Off-Balance-Sheet Financial Instruments

The fair value of commitments to extend credit is estimated using the fees currently charged to enter 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 interest rates. The fair value of stand-by letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.

At December 31, 2017 and 2016, the majority of off-balance-sheet items are variable rate instruments or convert to variable rate instruments if drawn upon. Therefore, the fair value of these items is largely based on fees, which are nominal and immaterial.

The carrying amounts and estimated fair values of financial instruments at December 31, 2017 and 2016 were as follows:



	December 31,
	2017				2016
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(In Thousands)
Financial assets:
Cash and short-term investments	$	122,313	$	122,313	$	91,059	$	91,059
Securities available-for-sale	407,446		407,446		194,090		194,090
Securities held-to-maturity	15,721		16,379		9,200		9,293
Restricted stock	16,572		16,572		10,092		10,092
Loans, net of allowance	1,995,103		2,016,530		1,069,366		1,080,820
Derivatives	420		420		993		993
Total financial assets	$	2,557,575	$	2,579,660	$	1,374,800	$	1,386,347
Financial liabilities:
Deposits	$	2,234,148	$	2,161,134	$	1,054,327	$	1,040,402
Short-term borrowings	145,993		145,396		186,009		185,910
Long-term borrowings	43,883		43,703		60,000		59,954
Derivatives	195		195		325		325
Total financial liabilities	$	2,424,219	$	2,350,428	$	1,300,661	$	1,286,591

Current accounting pronouncements require disclosure of the estimated fair value of financial instruments. Effective January 1, 2008, fair value is defined in accordance with FASB ASC 820-10 as disclosed above. Given the current market conditions, a portion of our loan portfolio is not readily marketable and market prices do not exist. We have not attempted to market our loans to potential buyers, if any exist, to determine the fair value of those instruments in accordance with the definition of FASB ASC 820-10. Since negotiated prices in illiquid markets depends upon the then present motivations of the buyer and seller, it is reasonable to assume that actual sales prices could vary widely from any estimate of fair value made without the benefit of negotiations. Additionally, changes in market interest rates can dramatically impact the value of financial instruments in a short period of time. Accordingly, the fair value measurements for loans included in the table above are unlikely to represent the instruments’ liquidation values.