Note (10)—Fair value of financial instruments:

ASC 820-10 establishes a framework for measuring the fair value of assets and liabilities according to a hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets and liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that are derived from assumptions based on management’s estimate of assumptions that market participants would use in pricing the asset or liability based on the best information available under the circumstances.

The hierarchy is broken down into the following three levels, based on the reliability of inputs:

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that are accessible at 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 for assets or liabilities that are derived from assumptions based on management’s estimate of assumptions that market participants would use in pricing the assets or liabilities.

The Company records the fair values of financial assets and liabilities on a recurring and non-recurring basis using the following methods and assumptions:

Available-for-sale securities—Available-for-sale securities are recorded at fair value on a recurring basis. Fair values for securities are based on quoted market prices, where available. If quoted prices are not available, fair values are based on quoted market prices of similar instruments or are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the pricing relationship or correlation among other benchmark quoted securities. Available-for-sale securities valued using quoted market prices of similar instruments or that are valued using matrix pricing are classified as Level 2. When significant inputs to the valuation are unobservable, the available-for-sale securities are classified within Level 3 of the fair value hierarchy.

Where no active market exists for a security or other benchmark securities, fair value is estimated by the Company with reference to discount margins for other high risk securities.

Loans held for sale—Loans held for sale are carried at fair value. If fair value is used, it is determined using current secondary market prices for loans with similar characteristics, that is, using Level 2 inputs.

Derivatives—The fair value of the interest rate swaps are based upon fair values provided from entities that engage in interest rate swap activity and is based upon projected future cash flows and interest rates. Fair value of commitments is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments, the difference between current levels of interest rates and the committed rates is also considered. These financial instruments are classified as Level 2.

Foreclosed real estate—Foreclosed real estate (“REO”) is comprised of commercial and residential real estate obtained in partial or total satisfaction of loan obligations. REO acquired in settlement of indebtedness is recorded at the lower of the carrying amount of the loan or the fair value of the real estate less costs to sell. Fair value is determined on a nonrecurring basis based on appraisals by qualified licensed appraisers and is adjusted for management’s estimates of costs to sell and holding period discounts. The valuations are classified as Level 3.

Mortgage servicing rights—Servicing rights are carried at the lower of amortized cost or fair value. Fair value is determined using an income approach with various assumptions including expected cash flows, market discount rates, prepayment speeds, servicing costs, and other factors. Mortgage servicing rights are disclosed as level 3.

Impaired loans—Loans considered impaired under FASB ASC 310, Receivables, are loans for which, based on current information and events, it is probable that the creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Fair value adjustments for impaired loans are recorded on a non-recurring basis as either partial write downs based on observable market prices or current appraisal of the collateral. Impaired loans are classified as Level 3.

The following methods were used to estimate the fair value of the Company’s financial instruments which were not previously presented.

Cash and cash equivalents—Cash and cash equivalents consist of cash and due from banks with other financial institutions and federal funds sold. The carrying amount reported in the consolidated balance sheets approximates the fair value based upon the short-term nature of these assets. Also included are interest-bearing deposits in financial institutions. Interest bearing deposits in financial institutions consist of interest bearing accounts at the Federal Reserve Bank and Federal Home Loan Bank. The carrying value reported in the consolidated balance sheets approximates the fair value based upon the short-term nature of the assets.

Federal Home Loan Bank stock—The carrying value of Federal Home Loan Bank stock reported in the consolidated balance sheets approximates the fair value as the stock is redeemable at the carrying value.

Loans—For variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based upon carrying values. Fixed rate loan fair values are estimated using a discounted cash flow analysis based upon interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

Deposits—The fair value disclosed for demand deposits (both interest bearing and noninterest bearing) and savings deposits are equal to the amount payable on demand as of the reporting date. The fair value of the time deposits is estimated using a discounted cash flow method based upon current rates for similar types of accounts.

Short term borrowings—The fair value of the lines of credit which represent federal funds purchased approximate the carrying value of the amounts reported on the balance sheet due to the short-term nature of these liabilities.

Securities sold under agreement to repurchase—The fair value of the securities sold under agreement to repurchase approximate the carrying value of the amounts reported on the balance sheet due to the short-term nature of these liabilities.

Long-term debt—The fair value of long-term debt is determined using discounted cash flows using current rates.

Accrued interest payable and receivable – The carrying amounts of accrued interest approximate fair value.

The estimated fair values of the Company’s financial instruments are as follows (in thousands):

			Fair Value
September 30, 2016	Carrying amount		Level 1		Level 2		Level 3		Total
Financial assets:
Cash and cash equivalents	$	117,297	$	117,297	$	—	$	—	$	117,297
Available-for-sale securities		553,357		—		548,808		4,549		553,357
Federal Home Loan Bank Stock		6,528		—		—		6,528		6,528
Loans, net		1,770,053		—		1,763,866		2,968		1,766,834
Loans held for sale		486,601		—		486,601		—		486,601
Interest receivable		7,040		—		7,040		—		7,040
Mortgage servicing rights, net		46,291		—		—		46,291		46,291
Derivatives		16,811		—		16,811		—		16,811
Financial liabilities:
Deposits:
Without stated maturities	$	2,241,048	$	2,241,048	$	—	$	—	$	2,241,048
With stated maturities		399,024		—		398,592		—		398,592
Securities sold under agreement to repurchase		29,137		29,137		—		—		29,137
Short term borrowings		80,000		80,000		—		—		80,000
Interest payable		518		176		342		—		518
Long-term debt		45,291		—		44,385		—		44,385
Derivatives		4,807		—		4,807		—		4,807

			Fair Value
December 31, 2015	Carrying amount		Level 1		Level 2		Level 3		Total
Financial assets:
Cash and cash equivalents	$	97,723	$	97,723	$	—	$	—	$	97,723
Available-for-sale securities		649,387		—		644,531		4,856		649,387
Federal Home Loan Bank Stock		6,528		—		—		6,528		6,528
Loans, net		1,677,403		—		1,638,506		36,951		1,675,457
Loans held for sale		273,196		—		273,196		—		273,196
Interest receivable		6,763		—		6,763		—		6,763
Mortgage servicing rights, net		29,711		—		—		29,711		29,711
Derivatives		6,023		—		6,023		—		6,023
Financial liabilities:
Deposits:
Without stated maturities	$	2,112,915		2,112,915	$	—	$	—		2,112,915
With stated maturities		325,559		—		323,624		—		323,624
Securities sold under agreement to repurchase		105,133		105,133		—		—		105,133
Short term borrowings		18,000		18,000		—		—		18,000
Interest payable		550		244		306		—		550
Long-term debt		56,616		—		55,484		—		55,484
Derivatives		369		—		369		—		369

The balances and levels of the assets measured at fair value on a recurring basis at September 30, 2016 are presented in the following tables (in thousands):

At September 30, 2016	Quoted prices in active markets for identical assets (liabilities) (level 1)		Significant other observable inputs (level 2)		Significant unobservable inputs (level 3)		Total
Recurring valuations:
Financial assets:
Available-for-sale securities:
U.S. government agency securities	$	—	$	2,501	$	—	$	2,501
Mortgage-backed securities		—		433,564		—		433,564
Municipals, tax-exempt		—		104,112		—		104,112
Treasury securities		—		4,506		—		4,506
Equity securities		—		4,125		4,549		8,674
Total	$	—	$	548,808	$	4,549	$	553,357
Loans held for sale		—		486,601		—		486,601
Derivatives		—		16,811		—		16,811
Financial Liabilities:
Derivatives		—		4,807		—		4,807

The balances and levels of the assets measured at fair value on a non-recurring basis at September 30, 2016 are presented in the following tables (in thousands):

At September 30, 2016	Quoted prices in active markets for identical assets (liabilities) (level 1)		Significant other observable inputs (level 2)		Significant unobservable inputs (level 3)		Total
Non-recurring valuations:
Financial assets:
Foreclosed assets	$	—	$	—	$	2,564	$	2,564
Mortgage servicing rights	$	—	$	—		46,291		46,291
Impaired loans:
Commercial and industrial		—		—		362		362
Commercial real estate:
Owner occupied		—		—		825		825
Non-owner occupied		—		—		1,352		1,352
Residential real estate:
1-4 family mortgage		—		—		110		110
Residential line of credit		—		—		315		315
Consumer and other		—		—		4		4
Total	$	—	$	—	$	2,968	$	2,968

The balances and levels of the assets measured at fair value on a recurring basis at December 31, 2015 are presented in the following tables (in thousands):

At December 31, 2015	Quoted prices in active markets for identical assets (liabilities) (level 1)		Significant other observable inputs (level 2)		Significant unobservable inputs (level 3)		Total
Recurring valuations:
Financial assets:
Available-for-sale securities:
U.S. government agency securities	$	—	$	33,808	$	—	$	33,808
Mortgage-backed securities		—		522,373		—		522,373
Municipals, tax-exempt		—		79,837		—		79,837
Treasury securities		—		4,485		—		4,485
Equity securities		—		4,028		4,856		8,884
Total	$	—	$	644,531	$	4,856	$	649,387
Loans held for sale		—		273,196		—		273,196
Derivatives		—		6,023		—		6,023
Financial Liabilities:
Derivatives	$	—	$	369	$	—	$	369

The balances and levels of the assets measured at fair value on a non-recurring basis at December 31, 2015 are presented in the following tables (in thousands):

At December 31, 2015	Quoted prices in active markets for identical assets (liabilities) (level 1)		Significant other observable inputs (level 2)		Significant unobservable inputs (level 3)		Total
Non-recurring valuations:
Financial assets:
Foreclosed assets	$	—	$	—	$	6,275	$	6,275
Impaired Loans:
Commercial and industrial		—		—		2,007		2,007
Commercial real estate:								—
Owner occupied		—		—		6,493		6,493
Non-owner occupied		—		—		7,572		7,572
Construction		—		—		6,896		6,896
Residential real estate:								—
1-4 family mortgage		—		—		6,127		6,127
Multifamily		—		—		36		36
Consumer and other		—		—		4		4
Total	$	—	$	—	$	29,135	$	29,135

There were no transfers between Level 1, 2 or 3 during the periods presented.

The following table provides a reconciliation for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs, or Level 3 inputs, during the nine months ended September 30, 2016 and 2015 (in thousands):

	Available-for-sale securities September 30,
	2016			2015
Balance at beginning of period	$	4,856		$	4,688
Realized gains included in net income		—			—
Unrealized gains included in other comprehensive income		—			118
Purchases		—			—
Sales		(307	)		—
Balance at end of period	$	4,549		$	4,806

The fair value of certain of the Company’s corporate are determined from information derived from external parties that calculate discounted cash flows using swap and LIBOR curves plus spreads that adjust for loss severities, volatility, credit risk and optionality. When available, broker quotes are used to validate the model. Industry research reports as well as assumptions about specific-issuer defaults and deferrals are reviewed and incorporated into the calculations. There is no established market for the Company’s equity securities, and as such, the Company has estimated that historical costs approximates market value.

The following table presents information as of September 30, 2016 about significant unobservable inputs (Level 3) used in the valuation of assets measured at fair value on a nonrecurring basis:

Financial instrument	Fair Value		Valuation technique	Significant Unobservable inputs	Range of inputs
Impaired loans	$	2,968	Appraised value of collateral	Discount for comparable sales	0%-30%
Foreclosed assets	$	2,564	Appraised value of property less costs to sell	Discount for costs to sell	0%-10%
Mortgage servicing rights, net	$	46,291	Discounted cash flows	See Note 6	See Note 6

The following table presents information as of December 31, 2015 about significant unobservable inputs (Level 3) used in the valuation of assets measured at fair value on a nonrecurring basis:

Financial instrument	Fair Value		Valuation technique	Significant Unobservable inputs	Range of inputs
Impaired loans	$	29,135	Appraised value of collateral	Discount for comparable sales	0%-30%
Foreclosed assets	$	6,275	Appraised value of property less costs to sell	Discount for costs to sell	0%-46%
Mortgage servicing rights, net	$	29,711	Discounted cash flows	See Note 6	See Note 6

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 the Company. Once received, a member of the lending administrative department 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.

Fair value option

The Company elected to measure all loans originated for sale at fair value under the fair value option as permitted under ASC 825. Electing to measure these assets at fair value reduces certain timing differences and better matches the changes in fair value of the loans with changes in the fair value of derivative instruments used to economically hedge them.

Net gains of $12,638 and $1,571 resulting from fair value changes of the mortgage loans were recorded in income during the nine months ended September 30, 2016 and 2015, respectively. The amount does not reflect changes in fair values of related derivative instruments used to hedge exposure to market-related risks associated with these mortgage loans. The change in fair value of both loans held for sale and the related derivative instruments are recorded in Mortgage Banking Income in the Consolidated Statements of Income.

The Company’s valuation of loans held for sale incorporates an assumption for credit risk; however, given the short-term period that the Company holds these loans, valuation adjustments attributable to instrument-specific credit risk is nominal. Interest income on loans held for sale measured at fair value is accrued as it is earned based on contractual rates and is reflected in loan interest income in the Consolidated Statements of Income.

The following table summarizes the differences between the fair value and the principal balance for loans held for sale measured at fair value as of September 30, 2016 and December 31, 2015:

September 30, 2016	Aggregate fair value		Aggregate Unpaid Principal Balance		Difference
Mortgage loans held for sale measured at fair value	$	486,601	$	465,735	$	20,866
Past due loans of 90 days or more		—		—		—
Nonaccrual loans		—		—		—

December 31, 2015
Mortgage loans held for sale measured at fair value	$	273,196	$	264,968	$	8,228
Past due loans of 90 days or more		—		—		—
Nonaccrual loans		—		—		—