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Fair Value of Financial Instruments

12 Months Ended

Dec. 31, 2019

Note 12. Fair Value of Financial Instruments

Fair Value Hierarchy

There are three levels of inputs in the fair value hierarchy that may be used to measure fair value. Financial instruments are considered Level 1 when valuation can be based on quoted prices in active markets for identical assets or liabilities. Level 2 financial instruments are valued using quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or models using inputs that are observable or can be corroborated by observable market data of substantially the full term of the assets or liabilities. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.

Financial Instruments Measured at Fair Value

The following sections provide a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the fair value hierarchy:

Investment securities: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, discounted cash flow or at net asset value per share. Level 2 securities would include US government agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Impaired loans: Impairment of a loan is based on the fair value of the collateral of the loan for collateral-dependent loans. Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. Impaired loans classified as Level 3 are based on management’s judgment and estimation.

Servicing assets: Servicing rights do not trade in an active, open market with readily observable prices. While sales of servicing rights do occur, the precise terms and conditions typically are not readily available. Accordingly, the Company estimates the fair value of servicing rights using discounted cash flow models incorporating numerous assumptions from the perspective of a market participant including servicing income, servicing costs, market discount rates and prepayment speeds. Due to the nature of the valuation inputs, servicing rights are classified within Level 3 of the valuation hierarchy.

Foreclosed assets: Foreclosed real estate is adjusted to fair value less selling costs upon transfer of the loans to foreclosed real estate. Subsequently, foreclosed real estate is carried at the lower of carrying value or fair value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. Given the lack of observable market prices for identical properties and market discounts applied to appraised values, the Company generally classifies foreclosed assets as non-recurring Level 3.

Mutual fund: The mutual fund is registered with the Securities and Exchange Commission as a closed-end, non-diversified management investment company and operates as an interval fund. The fund primarily invests in the unguaranteed portion of SBA504 First Lien Loans secured by owner-occupied commercial real estate. This investment is valued using quoted prices in markets that are not active and is classified as Level 2 within the valuation hierarchy.

Equity warrant assets: Fair value measurements of equity warrant assets of private companies are priced based on a Black-Scholes option pricing model to estimate the asset value by using stated strike prices, option expiration dates, risk-free interest rates and option volatility assumptions. Option volatility assumptions used in the Black-Scholes model are based on public companies that operate in similar industries as the companies in our private company portfolio. Option expiration dates are modified to account for estimates of actual life relative to stated expiration. Values are further adjusted for a general lack of liquidity due to the private nature of the associated underlying company. The Company classifies equity warrant assets within Level 3 of the valuation hierarchy.

Equity security investment with a non-readily determinable fair value: The following equity security investment is measured at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. When an observable price change in an orderly transaction occurs, the investment is classified as nonrecurring Level 1 within the valuation hierarchy.

Recurring Fair Value

The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.

December 31, 2019	Total		Level 1		Level 2		Level 3
Investment securities available-for-sale
US treasury securities	$	5,015	$	—	$	5,015	$	—
US government agencies		22,779		—		22,779		—
Mortgage-backed securities		503,297		—		503,297		—
Municipal bonds¹		8,954		—		8,862		92
Servicing assets²		35,365		—		—		35,365
Mutual fund		2,206		—		2,206		—
Equity warrant assets³		570		—		—		570
Total assets at fair value	$	578,186	$	—	$	542,159	$	36,027

December 31, 2018	Total		Level 1		Level 2		Level 3
Investment securities available-for-sale
US treasury securities	$	4,966	$	—	$	4,966	$	—
US government agencies		30,944		—		30,944		—
Mortgage-backed securities		343,581		—		343,581		—
Municipal bond¹		999		—		—		999
Servicing assets²		47,641		—		—		47,641
Mutual fund		2,099		—		2,099		—
Equity warrant assets³		527		—		—		527
Total assets at fair value	$	430,757	$	—	$	381,590	$	49,167

During the year ended December 31, 2019, the Company sold $900 thousand of a municipal bond to a third party and recorded a fair value adjustment loss of $8 thousand. During the year ended December 31, 2018, the Company purchased a municipal bond with a value of $1.0 million and recorded a fair value adjustment loss of $1 thousand.

2	See Note 7 for a rollforward of recurring Level 3 fair values for servicing assets.

3	During the years ended December 31, 2019 and 2018, the Company recorded net losses on derivative instruments of $53 thousand and $24 thousand, respectively.

Non-recurring Fair Value

The tables below present the recorded amount of assets and liabilities measured at fair value on a non-recurring basis.

December 31, 2019	Total		Level 1		Level 2		Level 3
Impaired loans	$	3,909	$	—	$	—	$	3,909
Foreclosed assets		5,612		—		—		5,612
Equity security investment with a non-readily determinable fair value		8,738		8,738		—		—
Total assets at fair value	$	18,259	$	8,738	$	—	$	9,521

December 31, 2018	Total		Level 1		Level 2		Level 3
Impaired loans	$	4,130	$	—	$	—	$	4,130
Foreclosed assets		1,094		—		—		1,094
Total assets at fair value	$	5,224	$	—	$	—	$	5,224

Level 3 Analysis

For Level 3 assets and liabilities measured at fair value on a non-recurring basis as of December 31, 2019 and December 31, 2018 the significant unobservable inputs used in the fair value measurements were as follows:

December 31, 2019

Level 3 Assets with Significant Unobservable Inputs	Fair Value		Valuation Technique	Significant Unobservable Inputs	Range
Municipal bond	$	92	Discounted expected cash flows	Discount rate Prepayment speed	4.55% 5.00%
Impaired loans	$	3,909	Discounted appraisals	Appraisal adjustments (1)	10% to 57%
Foreclosed assets	$	5,612	Discounted appraisals	Appraisal adjustments (1)	10% to 37%
Equity warrant assets	$	570	Black-Scholes option pricing model	Volatility Risk-free interest rate Marketability discount Remaining life	21-75% 1.90% 20% 8 - 10 years

December 31, 2018

Level 3 Assets with Significant Unobservable Inputs	Fair Value		Valuation Technique	Significant Unobservable Inputs	Range
Municipal bond	$	999	Discounted expected cash flows	Discount rate Prepayment speed	5.14% 5.00%
Impaired loans	$	4,130	Discounted appraisals	Appraisal adjustments (1)	8% to 48%
Foreclosed assets	$	1,094	Discounted appraisals	Appraisal adjustments (1)	9% to 37%
Equity warrant assets	$	527	Black-Scholes option pricing model	Volatility Risk-free interest rate Marketability discount Remaining life	20.40% 2.69% 20.00% 9 - 10 years

(1)	Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments.

Estimated Fair Value of Other Financial Instruments

GAAP also requires disclosure of fair value information about financial instruments carried at book value on the consolidated balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

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

December 31, 2019	Carrying Amount		Quoted Price In Active Markets for Identical Assets/Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Fair Value
Financial assets
Cash and due from banks	$	126,752	$	126,752	$	—	$	—	$	126,752
Federal funds sold		96,787		96,787		—		—		96,787
Certificates of deposit with other banks		7,250		7,568		—		—		7,568
Investment securities, available-for-sale		540,045		—		539,953		92		540,045
Loans held for sale		966,447		—		—		1,020,567		1,020,567
Loans and leases, net of allowance for loan and lease losses		2,599,052		—		—		2,659,681		2,659,681
Servicing assets		35,365		—		—		35,365		35,365
Mutual fund		2,206		—		2,206		—		2,206
Equity warrant assets		570		—		—		570		570
Financial liabilities
Deposits		4,229,122		—		4,213,657		—		4,213,657
Borrowings		14		—		—		14		14

December 31, 2018	Carrying Amount		Quoted Price In Active Markets for Identical Assets/Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Fair Value
Financial assets
Cash and due from banks	$	316,823	$	316,823	$	—	$	—	$	316,823
Certificates of deposit with other banks		7,250		7,442		—		—		7,442
Investment securities, available-for-sale		380,490		—		380,490		—		380,490
Loans held for sale		687,393		—		—		695,154		695,154
Loans and leases, net of allowance for loan and lease losses		1,810,985		—		—		1,807,528		1,807,528
Servicing assets		47,641		—		—		47,641		47,641
Mutual fund		2,099		—		2,099		—		2,099
Equity warrant assets		527		—		—		527		527
Financial liabilities
Deposits		3,149,583		—		3,117,941		—		3,117,941
Borrowings		1,457		—		—		1,457		1,457

- Definition

The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information.

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