FAIR VALUE

Fair value is 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. There are 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 Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: Securities available for sale are recorded at fair value on a recurring basis as follows: the fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where pricing on similar securities is not available, a third party is engaged to calculate the fair value using the Municipal Market Data curve (Level 3).

Loans Held for Sale, at Fair Value: The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan (Level 2).

Loans Measured at Fair Value: During the normal course of business, loans originated with the initial intention to sell but not ultimately sold, are transferred from held for sale to our portfolio of loans held for investment at fair value as the Company adopted the fair value option at origination. The fair value of these loans is determined by obtaining fair value pricing from a third-party software, and then layering an additional adjustment, ranging from 5 to 75 basis points, as determined by management, depending on the reason for the transfer from loans held for sale. Due to the adjustments made, the Company classifies the loans transferred from loans held for sale as recurring Level 3.

Mortgage Servicing Rights ("MSRs"): In accordance with GAAP, the Company must record impairment charges on mortgage servicing rights on a non-recurring basis when the carrying value exceeds the estimated fair value. The fair value of our MSRs is obtained from a third-party valuation company that uses a discounted cash flow valuation model which calculates the present value of estimated future net servicing cash flows, taking into consideration expected mortgage loan prepayment rates, discount rates, costs to service, contractual servicing fee income, ancillary income, late fees, replacement reserves and other economic factors that are determined based on current market conditions. The reliance on Level 3 inputs to derive at the fair value of MSRs results in a Level 3 classification.

Impaired Loans: Impaired loans are measured and recorded at fair value on a non-recurring basis. All of our nonaccrual loans and trouble debt restructured loans are considered impaired and are reviewed individually for the amount of impairment, if any. The fair value of impaired loans is estimated using one of several methods, including the fair value of the collateral or the present value of the expected future cash flows discounted at the loan's effective interest rate. For loans that are collateral dependent, the fair value of each loan’s collateral is generally based on estimated market prices from an independently prepared appraisal. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Non-real estate collateral may be valued using an appraisal, net book value per the borrower's financial statements, or aging reports, adjusted or discounted based on management's historical knowledge, changes in market conditions from the time of the valuation, and management's expertise and knowledge of the client and client's business. Such adjustments are considered unobservable and the fair value measurement is categorized as a Level 3 measurement.

Other Real Estate Owned: Other real estate owned assets are recorded at the lower of cost or fair value upon the transfer of a loan to other real estate owned and, subsequently, continue to be measured and carried at the lower of cost or fair value. The fair value of other real estate owned is based on recent real estate appraisals which are generally updated annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales, cost, and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Other real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Appraisals for both collateral-dependent impaired loans and real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by either the Company or the Company's appraisal services vendor. Once received, management reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. Management monitors the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.

Derivatives: Customer-initiated derivatives are traded in over-the counter markets where quoted market prices are not readily available. Fair value of customer-initiated derivatives is measured on a recurring basis using valuation models that use market observable inputs (Level 2).

Mortgage banking related derivatives including commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are recorded at fair value on a recurring basis. The fair value of these commitments is based on the fair value of related mortgage loans determined using observable market data (Level 2). Interest rate lock commitments are adjusted for expectations of exercise and funding. This adjustment is not considered to be material input.

Assets and liabilities measured at fair value on a recurring basis are summarized below:



(Dollars in thousands)	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
March 31, 2020
Securities available for sale:
U.S. government sponsored entities and agencies	$	9,775	$	—	$	9,775	$	—
State and political subdivision	127,680		—		125,870		1,810
Mortgage-backed securities: residential	10,294		—		10,294		—
Mortgage-backed securities: commercial	9,133		—		9,133		—
Collateralized mortgage obligations: residential	8,056		—		8,056		—
Collateralized mortgage obligations: commercial	30,061		—		30,061		—
U.S. Treasury	1,010		—		1,010		—
SBA	20,562		—		20,562		—
Asset backed securities	9,613		—		9,613		—
Corporate bonds	4,487		—		4,487		—
Total securities available for sale	230,671		—		228,861		1,810
Loans held for sale	18,305		—		18,305		—
Loans measured at fair value:
Residential real estate	3,712		—		—		3,712
Derivative assets:
Customer-initiated derivatives	13,551		—		13,551		—
Forward contracts related to mortgage loans to be delivered for sale	5		—		5		—
Interest rate lock commitments	1,783		—		1,783		—
Total assets at fair value	$	268,027	$	—	$	262,505	$	5,522
Derivative liabilities:
Customer-initiated derivatives	13,551		—		13,551		—
Forward contracts related to mortgage loans to be delivered for sale	1,566		—		1,566		—
Total liabilities at fair value	$	15,117	$	—	$	15,117	$	—



(Dollars 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, 2019
Securities available for sale:
State and political subdivision	$	93,747	$	—	$	93,747	$	—
Mortgage-backed securities: residential	10,565		—		10,565		—
Mortgage-backed securities: commercial	8,779		—		8,779		—
Collateralized mortgage obligations: residential	8,529		—		8,529		—
Collateralized mortgage obligations: commercial	23,181		—		23,181		—
U.S. Treasury	1,999		—		1,999		—
SBA	21,984		—		21,984		—
Asset backed securities	10,084		—		10,084		—
Corporate bonds	2,037		—		2,037		—
Total securities available for sale	$	180,905	$	—	$	180,905	$	—
Loans held for sale	13,889		—		13,889		—
Loans measured at fair value:
Residential real estate	4,063		—		—		4,063
Derivative assets:
Customer-initiated derivatives	4,684		—		4,684		—
Forward contracts related to mortgage loans to be delivered for sale	34		—		34		—
Interest rate lock commitments	256		—		256		—
Total assets at fair value	$	203,831	$	—	$	199,768	$	4,063
Derivative liabilities:
Customer-initiated derivatives	4,684		—		4,684		—
Forward contracts related to mortgage loans to be delivered for sale	33		—		33		—
Total liabilities at fair value	$	4,717	$	—	$	4,717	$	—

There were no transfers between levels within the fair value hierarchy, within a specific category, during the three months ended March 31, 2020 or year ended December 31, 2019.

The following table summarizes the changes in Level 3 assets measured at fair value on a recurring basis.



(Dollars in thousands)	Loans held for investment
For the three months ended March 31, 2020
Beginning balance	$	4,063
Transfers from loans held for sale	40
Gains (losses):
Recorded in "Mortgage banking activities"	(7		)
Repayments	(384		)
Ending balance	$	3,712
For the three months ended March 31, 2019
Beginning balance	$	4,571
Transfers from loans held for sale	239
Gains (losses):
Recorded in "Mortgage banking activities"	88
Repayments	(248		)
Ending balance	$	4,650

The Company has elected the fair value option for loans held for sale. These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loan and in accordance with the Company's policy on loans held for investment. There were no loans held for sale that were on nonaccrual status or 90 days past due as of March 31, 2020 or December 31, 2019.

As of March 31, 2020 and December 31, 2019, the aggregate fair value, contractual balance (including accrued interest), and gain or loss for loans held for sale carried at fair value was as follows:



(Dollars in thousands)	March 31, 2020		December 31, 2019
Aggregate fair value	$	18,305	$	13,889
Contractual balance	17,587		13,510
Unrealized gain	718		379

The total amount of gains as a result of changes in fair value of loans held for sale included in "Mortgage banking activities" for three months ended March 31, 2020 and 2019 were as follows:



	For the three months ended March 31,
(Dollars in thousands)	2020		2019
Change in fair value	$	339	$	83

Assets measured at fair value on a non-recurring basis are summarized below:



(Dollars in thousands)	Total		Significant Unobservable Inputs (Level 3)
March 31, 2020
Impaired loans:
Commercial and industrial	$	1,139	$	1,139
Mortgage servicing rights	196		196
Other real estate owned	2,093		2,093
Total	$	3,428	$	3,428
December 31, 2019
Impaired loans:
Commercial real estate	$	265	$	265
Commercial and industrial	261		261
Mortgage servicing rights	87		87
Other real estate owned	921		921
Total	$	1,534	$	1,534

The Company recorded specific reserves of $317 thousand and $161 thousand to reduce the value of these loans at March 31, 2020 and December 31, 2019, respectively, based on the estimated fair value of the underlying collateral. The Company also recorded chargeoffs of $108 thousand during the three months ended March 31, 2020 related to the impaired loans at fair value. There were chargeoffs of $298 thousand related to impaired loans at fair value during the year ended December 31, 2019.

The Company recorded a valuation allowance of $17 thousand related to mortgage servicing rights during the three months ended March 31, 2020. There was no valuation allowance recorded during the year ended December 31, 2019. There were no write downs recorded in other real estate owned during the three months ended March 31, 2020 or the year ended December 31, 2019.

The table below presents quantitative information about the significant unobservable inputs for assets measured at fair value on a nonrecurring basis at March 31, 2020 and December 31, 2019:



(Dollars in thousands)	Fair value at March 31, 2020		Valuation Technique(s)	Significant Unobservable Input(s)	Discount % Range
Impaired loans	$	1,139	Discounted appraisals; estimated net realizable value of collateral	Collateral discounts	10.00-80.00%
Mortgage servicing rights	196		Discounted cash flow	Prepayment speed	15.34	%
				Discount rate	8.25	%
Other real estate owned	2,093		Appraisal of property	Discounted appraisal value	18.00-41.00%



(Dollars in thousands)	Fair value at December 31, 2019		Valuation Technique(s)	Significant Unobservable Input(s)	Discount % Range
Impaired loans	$	526	Discounted appraisals; estimated net realizable value of collateral	Collateral discounts	10.00-50.00%
Mortgage servicing rights	87		Discounted cash flow	Prepayment speed	13.42	%
				Discount rate	8.50	%
Other real estate owned	921		Appraisal of property	Discounted appraisal value	18.00-36.00%

The carrying amounts and estimated fair values of financial instruments, excluding those previously presented unless otherwise noted, at March 31, 2020 and December 31, 2019 are noted in the table below. The estimated fair value of loans as of March 31, 2020 takes into account exit pricing as a result of our adoption of ASU No. 2016-01.



			Estimated Fair Value
(Dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
March 31, 2020
Financial assets:
Cash and cash equivalents	$	104,867	$	22,775	$	82,092	$	—	$	104,867
Federal Home Loan Bank stock	12,398		N/A		N/A		N/A		N/A
Net loans	1,453,418		—		—		1,498,580		1,498,580
Accrued interest receivable	6,019		—		2,027		3,992		6,019
Financial liabilities:
Deposits	1,470,608		—		1,490,547		—		1,490,547
Borrowings	211,787		—		216,964		—		216,964
Subordinated notes	44,447		—		40,950		—		40,950
Accrued interest payable	2,061		—		2,061		—		2,061
December 31, 2019
Financial assets:
Cash and cash equivalents	$	103,930	$	19,990	$	83,940	$	—	$	103,930
Federal Home Loan Bank stock	11,475		N/A		N/A		N/A		N/A
Net loans	1,214,935		—		—		1,203,639		1,203,639
Accrued interest receivable	4,403		—		1,236		3,167		4,403
Financial liabilities:
Deposits	1,135,428		—		1,138,202		—		1,138,202
Borrowings	212,225		—		212,125		—		212,125
Subordinated notes	44,440		—		47,100		—		47,100
Accrued interest payable	1,574		—		1,574		—		1,574

The methods and assumptions, not previously presented, used to estimate fair value are described as follows:

(a)Cash and Cash Equivalents

The carrying amounts of cash on hand and non-interest due from bank accounts approximate fair values and are classified as Level 1. The carrying amounts of fed funds sold and interest bearing due from bank accounts approximate fair values and are classified as Level 2.

(b)FHLB Stock

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

(c)Loans

Fair value of loans, excluding loans held for sale, are estimated as follows: Fair values for all loans are estimated using present value of future estimated cash flows, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously.

(d)Deposits

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 2 classification. Fair values for fixed and variable rate certificates of deposit are estimated using a present value of future estimated cash flows calculation that applies interest rates currently being offered on certificates of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(e) Borrowings

The fair values of the Company's short-term and long-term borrowings are estimated using present value of future estimated cash flows using current interest rates offered to the Company for similar types of borrowing arrangements, resulting in a Level 2 classification.

(f)Subordinated Notes

The fair value of the Company's subordinated notes is calculated based on present value of future estimated cash flows using current interest rates offered to the Company for similar types of borrowing arrangements, resulting in a Level 2 classification.

(g) Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 3 classification for receivable and a Level 2 classification for payable, consistent with their associated assets/liabilities.