Note 8. Fair Value Measurements

ASC 825, “ Financial Instruments”, requires disclosure of the estimated fair value of an entity’s assets and liabilities considered to be financial instruments. For the Company, as for most financial institutions, the majority of its assets and liabilities are considered to be financial instruments. However, many such instruments lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction. Accordingly, estimated fair values are determined by the Company using the best available data and an estimation methodology it believes to be suitable for each category of financial instruments. Also, it is the Company’s general practice and intent to hold its financial instruments to maturity whether or not categorized as “available-for-sale” and not to engage in trading or sales activities, except for the sale of commercial loans to secondary markets. For fair value disclosure purposes, the Company utilized certain value measurement criteria required under ASC 820, “Fair Value Measurements and Disclosures”, as discussed below. During the nine months ended September 30, 2018, there were no transfers between the three levels which categorize assets and liabilities by the type of information available for valuation purposes.

Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values.

Cash and cash equivalents, which are comprised of cash and due from banks, the Company’s balance at the Federal Reserve Bank and securities purchased under agreements to resell, had recorded values of $777.6 million and $908.9 million as of September 30, 2018 and December 31, 2017, respectively, which approximated fair values.

The estimated fair values of investment securities are based on quoted market prices, if available, or estimated using a methodology based on management’s inputs. The fair values of the Company’s investment securities held-to-maturity and loans held for sale are based on using “unobservable inputs” that are the best information available in the circumstances. Level 3 investment security fair values are based on the present value of cash flows, which discounts expected cash flows from principal and interest using yield to maturity at the measurement date.

FHLB and Atlantic Central Bankers Bank stock is held as required by those respective institutions and is carried at cost. Federal law requires a member institution of the FHLB to hold stock according to predetermined formulas. Atlantic Central Bankers Bank requires its correspondent banking institutions to hold stock as a condition of membership.

Commercial loans held for sale have estimated fair values based upon either market indications of the sales price of such loans from recent sales transactions or discounted cash flow analysis on an individual loan basis.

The net loan portfolio is valued using the present value of discounted cash flow where market prices were not available. The discount rate used in these calculations is the estimated current market rate adjusted for credit risk. Accrued interest receivable has a carrying value that approximates fair value.

On December 30, 2014, the Bank entered into an agreement for, and closed on, the sale of a portion of its discontinued commercial loan portfolio. The purchaser of the loan portfolio was a newly formed entity, 2014-1 LLC (Walnut Street). The price paid to the Bank for the loan portfolio which had a face value of approximately $267.6 million, was approximately $209.6 million, of which approximately $193.6 million was in the form of two notes issued by Walnut Street to the Bank; a senior note in the principal amount of approximately $178.2 million bearing interest at 1.5% per year and maturing in December 2024 and a subordinate note in the principal amount of approximately $15.4 million, bearing interest at 10.0% per year and maturing in December 2024. The balance of these notes comprises the balance of the investment in unconsolidated entity on the consolidated balance sheets. The fair value was initially established by the sales price and the investment is marked quarterly to fair value, as determined using a discounted cash flow analysis. The change in value of investment in unconsolidated entity in the consolidated statements of operations reflect changes in estimated fair value. Interest paid to the bank on the note is credited to principal.

Discontinued assets held for sale are recorded at the lower of cost basis or market value. For loans, market value was determined using the discounted cash flow approach which converts expected cash flows from the loan portfolio by unit of measurement to a present value estimate. Unit of measurement was determined by loan type and for significant loans on an individual loan basis. The fair values of the Company’s loans classified as assets held for sale are based on “unobservable inputs” that are based on available information. Level 3 fair values are based on the present value of cash flows by unit of measurement. For commercial loans other than SBA loans, a market adjusted rate to discount expected cash flows from outstanding principal and interest to expected maturity at the measurement date was utilized. For SBA loans, market indications for similar loans were utlitized. For other real estate owned, market value was based upon appraisals of the underlying collateral by third party appraisers, reduced by 7% to 10% for estimated selling costs.

The estimated fair values of demand deposits (comprised of interest and non-interest bearing checking accounts, savings accounts, and certain types of money market accounts) are equal to the amount payable on demand at the reporting date (generally, their carrying amounts). The fair values of securities sold under agreements to repurchase and short term borrowings are equal to their carrying amounts as they are short-term borrowings.

Time deposits, when outstanding, and subordinated debentures have a fair value estimated using a discounted cash flow calculation that applies current interest rates to discount expected cash flows. The carrying amount of accrued interest payable approximates its fair value. Long term borrowings resulted from sold loans which did not qualify for true sale accounting. They are presented in the amount of the principal of such loans.

The fair values of interest rate swaps, recorded as part of Other Assets, are determined using models that use readily observable market inputs and a market standard methodology applied to the contractual terms of the derivatives, including the period to maturity and interest rate indices.

The fair value of commitments to extend credit is estimated based on the amount of unamortized deferred loan commitment fees. The fair value of letters of credit is based on the amount of unearned fees plus the estimated cost to terminate the letters of credit. Fair values of unrecognized financial instruments, including commitments to extend credit, and the fair value of letters of credit are considered immaterial.

The following tables provide information regarding carrying amounts and estimated fair values (in thousands) as of the dates indicated:



	September 30, 2018
			Quoted prices in	Significant other	Significant
			active markets for	observable	unobservable
	Carrying	Estimated	identical assets	inputs	inputs
	amount	fair value	(Level 1)	(Level 2)	(Level 3)
Investment securities, available-for-sale	$ 1,274,417	$ 1,274,417	$ -	$ 1,222,371	$ 52,046
Investment securities, held-to-maturity	84,433	83,751	-	76,363	7,388
Securities purchased under agreements to resell	64,518	64,518	64,518	-	-
Federal Home Loan Bank and Atlantic Central Bankers Bank stock	1,113	1,113	-	-	1,113
Commercial loans held for sale	308,470	308,470	-	-	308,470
Loans, net of deferred loan fees and costs	1,496,773	1,494,821	-	-	1,494,821
Investment in unconsolidated entity	64,212	64,212	-	-	64,212
Assets held for sale from discontinued operations	226,026	226,026	-	-	226,026
Interest rate swaps, asset	2,830	2,830	-	2,830	-
Demand and interest checking	3,540,605	3,540,605	3,540,605	-	-
Savings and money market	317,453	317,453	317,453	-	-
Subordinated debentures	13,401	10,091	-	-	10,091
Securities sold under agreements to repurchase	158	158	158	-	-



	December 31, 2017
			Quoted prices in	Significant other	Significant
			active markets for	observable	unobservable
	Carrying	Estimated	identical assets	inputs	inputs
	amount	fair value	(Level 1)	(Level 2)	(Level 3)
Investment securities, available-for-sale	$ 1,294,484	$ 1,294,484	$ -	$ 1,253,840	$ 40,644
Investment securities, held-to-maturity	86,380	85,345	-	78,745	6,600
Securities purchased under agreements to resell	64,312	64,312	64,312	-	-
Federal Home Loan Bank and Atlantic Central Bankers Bank stock	991	991	-	-	991
Commercial loans held for sale	503,316	503,316	-	-	503,316
Loans, net of deferred loan fees and costs	1,392,228	1,391,701	-	-	1,391,701
Investment in unconsolidated entity	74,473	74,473	-	-	74,473
Assets held for sale from discontinued operations	304,313	304,313	-	-	304,313
Interest rate swaps, asset	1,243	1,243	-	1,243	-
Demand and interest checking	3,806,965	3,806,965	3,806,965	-	-
Savings and money market	453,877	453,877	453,877	-	-
Subordinated debentures	13,401	9,173	-	-	9,173
Securities sold under agreements to repurchase	217	217	217	-	-

The assets and liabilities measured at fair value on a recurring basis, segregated by fair value hierarchy, are summarized below (in thousands) as of the dates indicated:



		Fair Value Measurements at Reporting Date Using
		Quoted prices in active	Significant other	Significant
		markets for identical	observable	unobservable
	Fair value	assets	inputs	inputs
	September 30, 2018	(Level 1)	(Level 2)	(Level 3)

Investment securities, available-for-sale
U.S. Government agency securities	$ 53,963	$ -	$ 53,963	$ -
Asset-backed securities	206,228	-	206,228	-
Obligations of states and political subdivisions	67,906	-	67,906	-
Residential mortgage-backed securities	380,489	-	380,489	-
Collateralized mortgage obligation securities	266,449	-	266,449	-
Commercial mortgage-backed securities	299,382	-	247,336	52,046
Total investment securities available-for-sale	1,274,417	-	1,222,371	52,046
Commercial loans held for sale	308,470	-	-	308,470
Investment in unconsolidated entity	64,212	-	-	64,212
Assets held for sale from discontinued operations	226,026	-	-	226,026
Interest rate swaps, asset	2,830	-	2,830	-
	$ 1,875,955	$ -	$ 1,225,201	$ 650,754



		Fair Value Measurements at Reporting Date Using
		Quoted prices in active	Significant other	Significant
		markets for identical	observable	unobservable
	Fair value	assets	inputs	inputs
	December 31, 2017	(Level 1)	(Level 2)	(Level 3)

Investment securities, available-for-sale
U.S. Government agency securities	$ 49,902	$ -	$ 49,902	$ -
Asset-backed securities	270,085	-	270,085	-
Obligations of states and political subdivisions	75,849	-	75,849	-
Residential mortgage-backed securities	448,852	-	448,852	-
Collateralized mortgage obligation securities	246,493	-	246,493	-
Commercial mortgage-backed securities	203,303	-	162,659	40,644
Total investment securities available-for-sale	1,294,484	-	1,253,840	40,644
Commercial loans held for sale	503,316	-	-	503,316
Investment in unconsolidated entity	74,473	-	-	74,473
Assets held for sale from discontinued operations	304,313	-	-	304,313
Interest rate swaps, asset	1,243	-	1,243	-
	$ 2,177,829	$ -	$ 1,255,083	$ 922,746

In addition, ASC 820 establishes a common definition for fair value to be applied to assets and liabilities. It clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It also establishes a framework for measuring fair value and expands disclosures concerning fair value measurements. ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 1 valuation is based on quoted market prices for identical assets or liabilities to which the Company has access at the measurement date. Level 2 valuation is based on other observable inputs for the asset or liability, either directly or indirectly. This includes quoted prices for similar assets in active or inactive markets, inputs other than quoted prices that are observable for the asset or liability such as yield curves, volatilities, prepayment speeds, credit risks, default rates, or inputs that are derived principally from, or corroborated through, observable market data by market-corroborated reports. Level 3 valuation is based on “unobservable inputs” which the Company believes is the best information available in the circumstances. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The changes in the Company’s Level 3 assets measured at fair value on a recurring basis, segregated by fair value hierarchy level, year to date, are summarized below (in thousands):



	Fair Value Measurements Using
	Significant Unobservable Inputs
	(Level 3)

	Available-for-sale		Commercial loans
	securities		held for sale
	September 30, 2018	December 31, 2017	September 30, 2018	December 31, 2017
Beginning balance	$ 40,644	$ -	$ 503,316	$ 663,140
Transfers into level 3	-	19,441	-	-
Transfers out of level 3	(45,998)	-	-	-
Total gains or losses (realized/unrealized)
Included in earnings	-	-	18,097	19,883
Included in other comprehensive loss	(476)	(497)	-	-
Purchases, issuances, sales and settlements
Purchases	62,076	24,112	-
Issuances	-	-	485,198	521,914
Sales	-	-	(698,141)	(701,621)
Settlements	(4,200)	(2,412)	-	-
Ending balance	$ 52,046	$ 40,644	$ 308,470	$ 503,316

Total gains or (losses) year to date included
in earnings attributable to the change in
unrealized gains or losses relating to assets still
held at the reporting date as shown above.	$ -	$ -	$ (1,909)	$ 911


	Fair Value Measurements Using
	Significant Unobservable Inputs
	(Level 3)

	Investment in			Assets held for sale
	unconsolidated entity			from discontinued operations
		September 30, 2018	December 31, 2017	September 30, 2018	December 31, 2017
Beginning balance		$ 74,473	$ 126,930	$ 304,313	$ 360,711
Transfers into level 3		-	-	-	-
Transfers out of level 3		-	-	-	-
Total gains or losses (realized/unrealized)
Included in earnings		(2,981)	(20)	(198)	557
Included in other comprehensive income		-	-	-	-
Purchases, issuances, sales, settlements and charge-offs
Purchases		-	-	-	-
Issuances		-	-	551	11,450
Sales		-	-	(35,000)	-
Settlements		(7,280)	(52,437)	(32,896)	(52,450)
Charge-offs		-	-	(10,744)	(15,955)
Ending balance		$ 64,212	$ 74,473	$ 226,026	$ 304,313

Total gains or (losses) year to date included
in earnings attributable to the change in
unrealized gains or losses relating to assets still
held at the reporting date as shown above.		$ (2,981)	$ (20)	$ (198)	$ (4,776)



	Fair value at	Fair value at			Range at	Range at
Level 3 instruments only	September 30, 2018	December 31, 2017	Valuation techniques	Unobservable inputs	September 30, 2018	December 31, 2017

Investment securities, available-for-sale	$ 52,046	$ 40,644	Discounted cash flow	Discount rate	4.88% - 6.31%	7.0% - 9.5%
Investment securities, held-to-maturity	7,388	6,600	Discounted cash flow	Discount rate	8.22%	8.00%
Federal Home Loan Bank and Atlantic	1,113	991	Cost	N/A	N/A	N/A
Central Bankers Bank stock
Loans, net of deferred loan fees and	1,494,821	1,391,701	Discounted cash flow	Discount rate	4.21% - 7.43%	3.5% - 7.2%
costs
Commercial - SBA	193,372	165,176	Traders' pricing	Offered quotes	100 - 115.125	100 - 117.25
Commercial - fixed	94,351	118,608	Discounted cash flow	Discount rate	5.54% - 7.29%	4.85% - 7.05%
Commercial - floating	20,747	219,532	Discounted cash flow	Discount rate	6.15% - 7.44%	5.53% - 6.04%
Commercial loans held for sale	308,470	503,316
Investment in unconsolidated entity	64,212	74,473	Discounted cash flow	Discount rate	5.46%	4.75%
				Default rate	1.00%	1.00%
Assets held for sale from discontinued	226,026	304,313	Discounted cash flow	Discount rate,	5.00% - 10.39%	3.89% - 9.59%
operations				Credit analysis
Subordinated debentures	10,091	9,173	Discounted cash flow	Discount rate	8.22%	7.00%

Fair values in the above table which are estimated by the discounted cash flow method, or using other valuation techniques, are subject to uncertainty resulting from the discount rate used, or other assumptions as of the reporting date. The discount rates used are based on market comparables which vary with credit spreads and interest rate movements or expected interest rate movements. Changes in these factors could have a significant impact on estimated fair values.

Assets measured at fair value on a nonrecurring basis, segregated by fair value hierarchy, during the periods shown are summarized below (in thousands):



		Fair Value Measurements at Reporting Date Using
		Quoted prices in active	Significant other	Significant
		markets for identical	observable	unobservable
	Fair value	assets	inputs	inputs
Description	September 30, 2018	(Level 1)	(Level 2)	(Level 3)

Impaired loans - collateral dependent (!)	$ 4,063	$ -	$ -	$ 4,063
Other real estate owned	405	-	-	405
Intangible assets	4,229	-	-	4,229
	$ 8,697	$ -	$ -	$ 8,697



		Fair Value Measurements at Reporting Date Using
		Quoted prices in active	Significant other	Significant
		markets for identical	observable	unobservable
	Fair value	assets	inputs	inputs
Description	December 31, 2017	(Level 1)	(Level 2)	(Level 3)

Impaired loans - collateral dependent (!)	$ 3,559	$ -	$ -	3,559
Other real estate owned	450	-	-	450
Intangible assets	5,377	-	-	5,377
	$ 9,386	$ -	$ -	$ 9,386

(1)

The method of valuation approach for the impaired loans was the market value approach based upon appraisals of the underlying collateral by external appraisers, reduced by 7% to 10% for estimated selling costs. Intangible assets are valued based upon internal analyses.

At September 30, 2018, principal on impaired loans and troubled debt restructurings which is accounted for on the basis of the value of underlying collateral is shown at estimated fair value of $4.1 million. To arrive at that fair value, related loan principal of $6.2 million was reduced by specific reserves of $2.1 million within the allowance for loan losses as of that date, representing the deficiency between principal and estimated collateral values, which were reduced by costs to sell. When the deficiency is deemed uncollectible, it is charged off by reducing the specific reserve and decreasing principal. Included in the impaired balance at September 30, 2018 were ten troubled debt restructured loans with a balance of $2.4 million which had specific reserves of $771,000. Valuation techniques consistent with the market and/or cost approach were used to measure fair value and primarily included observable inputs for the individual impaired loans being evaluated such as recent sales of similar assets or observable market data for operational or carrying costs. In cases where such inputs were unobservable, the loan balance is reflected within the Level 3 hierarchy. The fair value of other real estate owned is based on an appraisal of the property using the market approach for valuation.