Note 6 – Fair Value of Financial Instruments

Accounting standards require that the Company adopt fair value measurement for financial assets and financial liabilities. This enhanced guidance for using fair value to measure assets and liabilities applies whenever other standards require or permit assets or liabilities to be measured at fair value. This guidance does not expand the use of fair value in any new circumstances.

Accounting standards establish a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by these standards are as follows:



Level I:	Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

Level II:	Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.

Level III:	Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

The methods of determining the fair value of assets and liabilities presented in this footnote are consistent with our methodologies disclosed in Note 17, "Fair Value of Financial Instruments" and Note 18, "Fair Value Measurement" of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of the Company's 2017 Annual Report on Form 10-K, except for the valuation of loans held for investment which was impact by the adoption of ASU 2016-01. In accordance with ASU 2016-01, the fair value of loans held for investment is estimated using a discounted cash flow analysis. The discount rates used to determine fair value use interest rate spreads that reflect factors such as liquidity, credit, and nonperformance risk of the loans. Loans are considered a Level 3 classification.

Assets Measured on a Recurring Basis

As required by accounting standards, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company classified investments in government securities as Level II instruments and valued them using the market approach. The following measurements are made on a recurring basis.

•

Available-for-sale investment securities – Available-for-sale investment securities are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security's credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level I securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level II securities include mortgage-backed securities issued by government sponsored entities and private label entities, municipal bonds, and corporate debt securities. There have been no changes in valuation techniques for the three months ended March 31, 2018. Valuation techniques are consistent with techniques used in prior periods.


•	Loans held for sale – The fair value of mortgage loans held for sale is determined, when possible, using quoted secondary-market prices or investor commitments. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan, which would be used by other market participants.


•	Interest rate lock commitment – The Company estimates the fair value of interest rate lock commitments based on the value of the underlying mortgage loan, quoted mortgage-backed security prices, and estimates of the fair value of the mortgage servicing rights and the probability that the mortgage loan will fund within the terms of the interest rate lock commitments.


•	Mortgage-backed security hedges – MBS hedges are considered derivatives and are recorded at fair value based on observable market data of the individual mortgage-backed security.


•	Interest rate cap – The fair value of the interest rate cap is determined at the end of each quarter by using Bloomberg Finance which values the interest rate cap using observable inputs from forward and futures yield curves as well as standard market volatility.


•	Interest rate swap – Interest rate swaps are recorded at fair value based on third party vendors who compile prices from various sources and may determine fair value of identical or similar instruments by using pricing models that consider observable market data.

The following tables present the assets reported on the consolidated statements of financial condition at their fair value on a recurring basis as of March 31, 2018 and December 31, 2017 by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.



	March 31, 2018
(Dollars in thousands)	Level I		Level II		Level III		Total
Assets:
U.S. Government Agency securities	$	—	$	80,795	$	—	$	80,795
U.S. Sponsored Mortgage backed securities	—		56,318		—		56,318
Municipal securities	—		57,534		22,571		80,105
Other securities	—		9,286		—		9,286
Equity securities	6,079		—		900		6,979
Loans held for sale	—		51,280		—		51,280
Interest rate lock commitment	—		—		2,312		2,312
Interest rate swap	—		765		—		765
Interest rate cap	—		103		—		103
Liabilities:
Interest rate swap	—		765		—		765
Mortgage-backed security hedges	—		114		—		114



	December 31, 2017
(Dollars in thousands)	Level I		Level II		Level III		Total
Assets:
U.S. Government Agency securities	$	—	$	80,945	$	—	$	80,945
U.S. Sponsored Mortgage backed securities	—		58,154		—		58,154
Municipal securities	—		52,933		22,909		75,842
Equity securities	1,607		14,959		—		16,566
Loans held for sale	—		66,794		—		66,794
Interest rate lock commitment	—		—		1,426		1,426
Interest rate swap	—		268		—		268
Interest rate cap	—		33		—		33
Liabilities:
Interest rate swap	—		268		—		268
Mortgage-backed security hedges	—		78		—		78

The following table represents recurring level III assets:

(Dollars in thousands)	Interest Rate Lock Commitments		Municipal Securities			Total
Balance at December 31, 2017	$	1,426	$	22,909		$	24,335
Realized and unrealized gains included in earnings	886		—			886
Unrealized loss included in other comprehensive income (loss)	—		(338		)	(338		)
Balance at March 31, 2018	$	2,312	$	22,571		$	24,883

Balance at December 31, 2016	$	1,546	$	6,135		$	7,681
Realized and unrealized gains included in earnings	1,309		—			1,309
Unrealized gain included in other comprehensive income (loss)	—		54			54
Balance at March 31, 2017	$	2,855	$	6,189		$	9,044

Assets Measured on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain financial assets, financial liabilities, non-financial assets, and non-financial liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market value that were recognized at fair value below cost at the end of the period. Certain non-financial assets measured at fair value on a nonrecurring basis include foreclosed assets (upon initial recognition or subsequent impairment), non-financial assets and non-financial liabilities measured at fair value in the second step of a goodwill impairment test, and intangible assets and other non-financial long-lived assets measured at fair value for impairment assessment. Non-financial assets measured at fair value on a nonrecurring basis during 2018 and 2017 include certain foreclosed assets which, upon initial recognition, were remeasured and reported at fair value through a charge-off to the allowance for possible loan losses and certain foreclosed assets which, subsequent to their initial recognition, were remeasured at fair value through a write-down included in other noninterest expense.

•

Impaired loans – Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment using one of several methods, including collateral value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Collateral values are estimated using Level II inputs based on observable market data or Level III inputs based on customized discounting criteria. For a majority of impaired real estate related loans, the Company obtains a current external appraisal. Other valuation techniques are used as well, including internal valuations, comparable property analysis and contractual sales information.

•

Other real estate owned – Other real estate owned, which is obtained through the Bank’s foreclosure process is valued utilizing the appraised collateral value. Collateral values are estimated using Level II inputs based on observable market data or Level III inputs based on customized discounting criteria. At the time, the foreclosure is completed, the Company obtains a current external appraisal.

Assets measured at fair value on a nonrecurring basis as of March 31, 2018 and December 31, 2017 are included in the table below:



	March 31, 2018
(Dollars in thousands)	Level I		Level II		Level III		Total
Impaired loans	$	—	$	—	$	13,836	$	13,836
Other real estate owned	—		—		1,910		1,910



	December 31, 2017
(Dollars in thousands)	Level I		Level II		Level III		Total
Impaired loans	$	—	$	—	$	14,368	$	14,368
Other real estate owned	—		—		1,346		1,346

The following tables presents quantitative information about the Level III significant unobservable inputs for assets and liabilities measured at fair value at March 31, 2018 and December 31, 2017.



	Quantitative Information about Level III Fair Value Measurements
(Dollars in thousands)	Fair Value		Valuation Technique	Unobservable Input	Range
March 31, 2018
Nonrecurring measurements:
Impaired loans	$	13,836	Appraisal of collateral ¹	Appraisal adjustments ²	20% - 62%
				Liquidation expense ³	5% - 10%

Other real estate owned	$	1,910	Appraisal of collateral ¹	Appraisal adjustments ²	20% - 30%
				Liquidation expense ³	5% - 10%

Recurring measurements:
Municipal securities	$	22,571	Appraisal of bond ³	Bond appraisal adjustment ⁴	5% - 15%

Interest rate lock commitments	$	2,312	Pricing model	Pull through rates	80% - 83%



	Quantitative Information about Level III Fair Value Measurements
(Dollars in thousands)	Fair Value		Valuation Technique	Unobservable Input	Range
December 31, 2017
Nonrecurring measurements:
Impaired loans	$	14,368	Appraisal of collateral ¹	Appraisal adjustments ²	20% - 62%
				Liquidation expense ³	5% - 10%

Other real estate owned	$	1,346	Appraisal of collateral ¹	Appraisal adjustments ²	20% - 30%
				Liquidation expense ³	5% - 10%

Recurring measurements:
Municipal securities	$	22,909	Appraisal of bond ³	Bond appraisal adjustment ⁴	5% - 15%

Interest rate lock commitments	$	1,426	Pricing model	Pull through rates	73% - 85%

¹ Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level III inputs which are not identifiable.

² Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses. The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

³ Fair value determined through independent analysis of liquidity, rating, yield and duration.

⁴ Appraisals may be adjusted for qualitative factors such as local economic conditions.

Estimated fair values have been determined by the Company using historical data, as generally provided in the Company’s regulatory reports, and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods and assumptions are set forth below for the Company’s other financial instruments.


•	Cash and cash equivalents: –The carrying amounts for cash and cash equivalents approximate fair value because they have original maturities of 90 days or less and do not present unanticipated credit concerns.


•	Certificates of deposits – The fair values for certificates of deposits are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for certificates of deposits with similar terms of investors. No prepayments of principal are assumed.

•

Securities – U.S. treasury, government agency, mortgage-backed securities, certain municipal securities, and corporate bonds are generally measured at fair value using a third-party pricing service or recent comparable market transactions in similar or identical securities and are classified as Level II instruments. Equity securities are measured at fair value using observable closing prices and are classified as Level I instruments if they are traded on a heavily active market and as Level II instruments if the observable closing price is from a less than active market. Certain local municipal securities related to tax increment financing (“TIF”) are independently valued and classified as Level III instruments.


•	Loans held for sale – Loans held for sale are reported at fair value. These loans currently consist of one-to-four-family residential loans originated for sale in the secondary market. Fair value is based on committed market rates or the price secondary markets are currently offering for similar loans using observable market data. (Level II)

•

Loans – The fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms of borrowers of similar credit quality. Additionally, to be consistent with the requirements under FASB ASC Topic 820 for Fair Value Measurements and Disclosures, the loans were valued at a price that represents the Company's exit price or the price at which these instruments would be sold or transferred.


•	Mortgage servicing rights – The carrying value of mortgage servicing rights approximates their fair value due to the immateriality of the balance.

•

Interest rate lock commitment – For mortgage interest rate locks, the fair value is based on either (i) the price of the underlying loans obtained from an investor for loans that will be delivered on a best efforts basis or (ii) the observable price for individual loans traded in the secondary market for loans that will be delivered on a mandatory basis less (iii) expected costs to deliver the interest rate locks, any expected “pull through rate” is multiplied by this calculation to estimate the derivative value.


•	Mortgage-backed security hedges – MBS hedges are used to mitigate interest rate risk for residential mortgage loans held for sale and interest rate locks and manage expected funding percentages. These instruments are considered derivatives and are recorded at fair value based on observable market data of the individual mortgage-backed securities.


•	Interest rate cap – The fair value of the interest rate cap is determined at the end of each quarter by using Bloomberg Finance which values the interest rate cap using observable inputs from forward and futures yield curves as well as standard market volatility.


•	Interest rate swap – Interest rate swaps are recorded at fair value based on third party vendors who compile prices from various sources and may determine fair value of identical or similar instruments by using pricing models that consider observable market data.


•	Accrued interest receivable and payable and repurchase agreements – The carrying values of accrued interest receivable and payable approximate their fair values.

•

Deposits – The fair values of demand deposits (i.e., noninterest bearing checking, NOW and money market), savings accounts and other variable rate deposits approximate their carrying values. Fair values of fixed maturity deposits are estimated using a discounted cash flow methodology at rates currently offered for deposits with similar remaining maturities. Any intangible value of long-term relationships with depositors is not considered in estimating the fair values disclosed.


•	FHLB and other borrowings – The fair values for loans are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for loans with similar terms of borrowers of similar credit quality. No prepayments of principal are assumed.


•	Subordinated debt – The fair values for debt are computed based on scheduled future cash flows of principal and interest, discounted at interest rates currently offered for debt with similar terms of borrowers of similar credit quality. No prepayments of principal are assumed.

•

Off-balance sheet instruments – The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of agreements and the present credit standing of the counterparties. The amounts of fees currently charged on commitments and standby letters of credit are deemed insignificant, and therefore, the estimated fair values and carrying values are not shown.

The carrying values and estimated fair values of the Company’s financial instruments are summarized as follows:

Fair Value Measurements at:

(Dollars in thousands)	Carrying Value		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level I)		Significant Other Observable Inputs (Level II)		Significant Unobservable Inputs (Level III)
March 31, 2018
Financial assets:
Cash and cash equivalents	$	23,630	$	23,630	$	23,630	$	—	$	—
Certificates of deposits with other banks	14,778		14,695		—		14,695		—
Securities available-for-sale	226,504		226,504		—		203,933		22,571
Equity securities	6,979		6,979		6,079		—		900
Loans held for sale	51,280		51,280		—		51,280		—
Loans, net	1,147,106		1,137,716		—		—		1,137,716
Mortgage servicing rights	179		179		—		—		179
Interest rate lock commitment	2,312		2,312		—		—		2,312
Interest rate swap	765		765		—		765		—
Interest rate cap	103		103		—		103		—
Accrued interest receivable	5,915		5,915		—		1,644		4,271

Financial liabilities:
Deposits	$	1,153,907	$	1,114,189	$	—	$	1,114,189	$	—
Repurchase agreements	20,676		20,676		—		20,676		—
FHLB and other borrowings	207,370		207,372		—		207,372		—
Mortgage-backed security hedges	114		114		—		114		—
Interest rate swap	765		765		—		765		—
Accrued interest payable	908		908		—		908		—
Subordinated debt	33,524		35,117		—		35,117		—

December 31, 2017
Financial assets:
Cash and cash equivalents	$	20,305	$	20,305	$	20,305	$	—	$	—
Certificates of deposits with other banks	14,778		14,985		—		14,695		—
Securities available-for-sale	231,507		231,507		1,607		206,991		22,909
Loans held for sale	66,794		66,794		—		66,794		—
Loans, net	1,096,063		1,093,824		—		—		1,093,824
Mortgage servicing rights	182		182		—		—		182
Interest rate lock commitment	1,426		1,426		—		—		1,426
Interest rate swap	268		268		—		268		—
Interest rate cap	33		33		—		33		—
Accrued interest receivable	5,296		5,296		—		1,241		4,055

Financial liabilities:
Deposits	$	1,159,580	$	1,126,615	$	—	$	1,126,615	$	—
Repurchase agreements	22,403		22,403		—		22,403		—
FHLB and other borrowings	152,169		152,190		—		152,190		—
Mortgage-backed security hedges	78		78		—		78		—
Interest rate swap	268		268		—		268		—
Accrued interest payable	643		643		—		643		—
Subordinated debt	33,524		35,117		—		35,117		—

Fair value estimates are made at a specific point in time, based on relevant market 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. Fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.