NOTE 10: FAIR VALUE OF FINANCIAL INSTRUMENTS

FASB ASC Topic 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy based on the nature of data inputs for fair value determinations, under which DNB is required to value each asset within its scope using assumptions that market participations would utilize to value that asset. When DNB uses its own assumptions, it is required to disclose additional information about the assumptions used and the effect of the measurement on earnings or the net change in assets for the period.

The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:

Level 1—Quoted prices in active markets for identical securities.

Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active and model derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3—Instruments whose significant value drivers are unobservable.

A description of the valuation methodologies used for assets measured at fair value is set forth below:

DNB’s available-for-sale investment securities, which generally include U.S. government agencies and mortgage backed securities, collateralized mortgage obligations, corporate bonds and equity securities are reported at fair value. These securities are valued by an independent third party (“preparer”). The preparer’s evaluations are based on market data. They utilize evaluated pricing models that vary by asset and incorporate available trade, bid and other market information. For securities that do not trade on a daily basis, their evaluated pricing applications apply available information such as benchmarking and matrix pricing. The market inputs normally sought in the evaluation of securities include benchmark yields, reported trades, broker/dealer quotes (only obtained from market makers or broker/dealers recognized as market participants), issuer spreads, two-sided markets, benchmark securities, bid, offers and reference data. For certain securities additional inputs may be used or some market inputs may not be applicable. Inputs are prioritized differently on any given day based on market conditions.

U.S. Government agencies are evaluated and priced using multi‑dimensional relational models and option adjusted spreads. State and municipal securities are evaluated on a series of matrices including reported trades and material event notices. Mortgage backed securities are evaluated using matrix correlation to treasury or floating index benchmarks, prepayment speeds, monthly payment information and other benchmarks. Other securities are evaluated using a broker-quote based application, including quotes from issuers.

Impaired loans are those loans that the Bank has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

OREO assets are adjusted to fair value less estimated selling costs upon transfer of the loans to OREO establishing a new cost basis. Subsequently, OREO assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. There assets are included as Level 3 fair values.

The following table summarizes the assets at March 31, 2016 and December 31, 2015 that are recognized on DNB’s statement of financial condition using fair value measurement determined based on the differing levels of input:



		March 31, 2016

(Dollars in thousands)		Level 1		Level 2		Level 3		Fair Value
Assets Measured at Fair Value on a Recurring Basis
AFS Investment Securities:
US Government agency obligations	$	-	$	59,116	$	-	$	59,116
GSE mortgage-backed securities		-		34,228		-		34,228
Collateralized mortgage obligations GSE		-		15,389		-		15,389
Corporate bonds		-		19,872		-		19,872
State and municipal tax-exempt		-		12,768		-		12,768
Total	$	-	$	141,373	$	-	$	141,373


Assets Measured at Fair Value on a Nonrecurring Basis
Impaired loans	$	-	$	-	$	690	$	690
Total	$	-	$	-	$	690	$	690



		December 31, 2015

(Dollars in thousands)		Level 1		Level 2		Level 3		Fair Value
Assets Measured at Fair Value on a Recurring Basis
AFS Investment Securities:
US Government agency obligations	$	-	$	58,208	$	-	$	58,208
GSE mortgage-backed securities		-		40,351		-		40,351
Collateralized mortgage obligations GSE		-		15,806		-		15,806
Corporate bonds		-		20,571		-		20,571
State and municipal tax-exempt		-		17,443		-		17,443
Total	$	-	$	152,379	$	-	$	152,379


Assets Measured at Fair Value on a Nonrecurring Basis
Impaired loans	$	-	$	-	$	964	$	964
OREO and other repossessed property		-		-		682		682
Total	$	-	$	-	$	1,646	$	1,646

The following table presents additional information about assets measured at fair value on a nonrecurring basis and for which DNB has utilized Level 3 inputs to determine fair value:



March 31, 2016
Quantitative Information about Level 3 Fair Value Measurement

		Fair Value	Valuation		Range
(Dollars in thousands)		Estimate	Techniques	Unobservable Input	(Weighted Average)
Impaired loans - Residential mortgage	$	143	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loans - Commercial term		79	Appraisal of	Appraisal adj. (2)	-72%	to	-72%	(-72%)
			collateral (1)	Disposal costs (2)	-11%	to	-11%	(-11%)
Impaired loans - Commercial construction		358	Appraisal of	Appraisal adj. (2)	-20%	to	-20%	(-20%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loans - Home equity		6	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loans - Consumer other		104	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loan total	$	690

(1)

(2)



December 31, 2015
Quantitative Information about Level 3 Fair Value Measurement

		Fair Value	Valuation		Range
(Dollars in thousands)		Estimate	Techniques	Unobservable Input	(Weighted Average)
Impaired loans - Residential mortgage	$	115	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loans - Commercial mortgage		97	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-13%	to	-13%	(-13%)
Impaired loans - Commercial term		90	Appraisal of	Appraisal adj. (2)	-72%	to	-72%	(-72%)
			collateral (1)	Disposal costs (2)	-11%	to	-11%	(-11%)
Impaired loans - Commercial construction		559	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loans - Consumer other		103	Appraisal of	Appraisal adj. (2)	0%	to	0%	(0%)
			collateral (1)	Disposal costs (2)	-8%	to	-8%	(-8%)
Impaired loan total	$	964
Other real estate owned	$	682		Disposal costs (2)	-8%	to	-8%	(-8%)

⁽¹⁾

Fair value is generally determined through independent appraisals or sales contracts of the underlying collateral, which generally include various level 3 inputs which are not identifiable.

⁽²⁾

Appraisals are adjusted by management for qualitative factors and disposal costs.

Impaired loans. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $5.1 million at March 31, 2016. Of this, $884,000 had specific valuation allowances of $200,000, leaving a fair value of $684,000 as of March 31, 2016. DNB had $39,000 in impaired loans that were partially charged down by $33,000, leaving $6,000 at fair value as of March 31, 2016. The total fair value of impaired loans at March 31, 2016 was $690,000.

Impaired loans had a carrying amount of $5.0 million at December 31, 2015. Of this, $307,000 had specific valuation allowances of $114,000, leaving a fair value of $193,000 at December 31, 2015. In addition, DNB had $931,000 in impaired loans that were partially charged down by $160,000, leaving $771,000 at fair value as of December 31, 2015. The total fair value of impaired loans at December 31, 2015 was $964,000.

Other Real Estate Owned & other repossessed property. Other real estate owned (“OREO”) consists of properties acquired as a result of, or in-lieu-of, foreclosure. Properties or other assets are classified as OREO and other repossessed property are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying value or fair value, less estimated costs to sell. Costs relating to the development or improvement of the assets are capitalized and costs relating to holding the assets are charged to expense. DNB had $2.6 million of such assets at March 31, 2016, $2.4 million of which was OREO and $165,000 was in other repossessed property. DNB had $2.6 million of such assets at December 31, 2015, which consisted of $2.4 million in OREO and $165,000 in other repossessed property. Subsequent to the repossession of these assets, DNB did not write down the carrying values of OREO during the three month period ending March 31, 2016. DNB did not write down the carrying values of OREO in the three month period ending March 31, 2015.

DNB's policy is to recognize transfer between levels as of the actual date of the event or change in circumstances that caused the transfer. There were no transfers between Level 1 and 2 for the three months ended March 31, 2016.

Below is management’s estimate of the fair value of all financial instruments, whether carried at cost or fair value on the Company’s consolidated balance sheet. The carrying amounts and fair values of financial instruments at March 31, 2016 and December 31, 2015 are as follows:



		March 31, 2016

		Carrying		Fair
(Dollars in thousands)		Amount		Value		Level 1		Level 2		Level 3
Financial assets
Cash and cash equivalents	$	38,740	$	38,740	$	38,740	$	-	$	-
AFS investment securities		141,373		141,373		-		141,373		-
HTM investment securities		65,650		66,797		-		64,797		2,000
Restricted stock		3,166		3,166		-		3,166		-
Loans, net of allowance, including impaired		484,194		468,013		-		-		468,013
Accrued interest receivable		2,569		2,569		-		2,569		-
Financial liabilities
Deposits:
Non-interest-bearing deposits		131,951		131,951		-		131,951		-
Interest-bearing deposits		415,342		415,342		-		415,342		-
Time deposits		71,264		71,098		-		71,098		-
Brokered deposits		18,498		18,566		-		18,566		-
Repurchase agreements		21,661		21,661		-		21,661		-
FHLBP advances		20,000		20,172		-		20,172		-
Junior subordinated debentures and other borrowings		9,279		8,243		-		8,243		-
Subordinated debt		9,750		9,304		-		9,304		-
Accrued interest payable		313		313		-		313		-
Off-balance sheet instruments		-		-		-		-		-



		December 31, 2015

		Carrying		Fair
(Dollars in thousands)		Amount		Value		Level 1		Level 2		Level 3
Financial assets
Cash and cash equivalents	$	21,119	$	21,119	$	21,119	$	-	$	-
AFS investment securities		152,379		152,379		-		152,379		-
HTM investment securities		67,829		68,431		-		66,431		2,000
Restricted stock		3,447		3,447		-		3,447		-
Loans held-for-sale		-		-		-		-		-
Loans, net of allowance, including impaired		476,823		461,925		-		-		461,925
Accrued interest receivable		2,410		2,410		-		2,410		-
Financial liabilities
Deposits:
Non-interest-bearing deposits		125,581		125,581		-		125,581		-
Interest-bearing deposits		396,188		396,188		-		396,188		-
Time deposits		66,018		65,697		-		65,697		-
Brokered deposits		18,488		18,327		-		18,327		-
Repurchase agreements		32,416		32,416		-		32,416		-
FHLBP advances		30,000		30,210		-		30,210		-
Junior subordinated debentures and other borrowings		9,279		7,889		-		7,889		-
Subordinated debt		9,750		9,999		-		9,999		-
Accrued interest payable		345		345		-		345		-
Off-balance sheet instruments		-		-		-		-		-

The specific estimation methods and assumptions used can have a substantial impact on the resulting fair values of financial instruments. Following is a brief summary of the significant assumptions, methods, and estimates used in estimating fair value.

Limitations 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 DNB’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of DNB’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.

Cash and Cash Equivalents, Accrued Interest Receivable and Accrued Interest Payable The carrying amounts for short-term investments (cash and cash equivalents) and accrued interest receivable and payable approximate fair value.

Loans Held-for-Sale The fair value of loans held-for-sale is determined, when possible, using quoted secondary-market prices. If no such quotes prices exist, the fair value of a loan is determined using quoted prices for a similar loan or loans, adjusted for the specific attributes of that loan.

Investment Securities The fair value of investment securities are determined by an independent third party (“preparer”). The preparer’s evaluations are based on market data. They utilize evaluated pricing models that vary by asset and incorporate available trade, bid and other market information. For securities that do not trade on a daily basis, their evaluated pricing applications apply available information such as benchmarking and matrix pricing. The market inputs normally sought in the evaluation of securities include benchmark yields, reported trades, broker/dealer quotes (only obtained from market makers or broker/dealers recognized as market participants), issuer spreads, two-sided markets, benchmark securities, bid, offers and reference data. For certain securities additional inputs may be used or some market inputs may not be applicable. Inputs are prioritized differently on any given day based on market conditions.

U.S. Government agencies are evaluated and priced using multi‑dimensional relational models and option adjusted spreads. State and municipal securities are evaluated on a series of matrices including reported trades and material event notices. Mortgage backed securities are evaluated using matrix correlation to treasury or floating index benchmarks, prepayment speeds, monthly payment information and other benchmarks. Other investments are evaluated using a broker‑ quote based application, including quotes from issuers. The carrying amount of non-readily marketable equity securities approximates liquidation value.

Restricted Stock The carrying amount of restricted investment in Federal Home Loan Bank stock, Federal Reserve stock and ACBB stock approximates fair value, and considers the limited marketability of such securities.

Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial mortgages, residential mortgages, consumer and non-accrual loans. The fair value of performing loans is calculated by discounting expected cash flows using an estimated market discount rate. Expected cash flows include both contractual cash flows and prepayments of loan balances. Prepayments on consumer loans were determined using the median of estimates of securities dealers for mortgage-backed investment pools.

The estimated discount rate considers credit and interest rate risk inherent in the loan portfolios and other factors such as liquidity premiums and incremental servicing costs to an investor. Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale.

The fair value for non-accrual loans not based on fair value of collateral is derived through a discounted cash flow analysis, which includes the opportunity costs of carrying a non-performing asset. An estimated discount rate was used for these non-accrual loans, based on the probability of loss and the expected time to recovery.

Deposits The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate money market accounts, savings accounts, and interest checking accounts approximate their fair values at the reporting date. Fair values for fixed-rate CDs and brokered deposits (all of which are CDs) are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. Of the $18.5 million in brokered deposits, $4.0 million matures in 2016, $6.1 million matures in 2017, $3.2 million matures in 2018, and $5.3 million matures in 2019.

Federal Home Loan Bank of Pittsburgh advances The fair value of the FHLBP advances is obtained from the FHLB and is calculated by discounting contractual cash flows using an estimated interest rate based on the current rates available for debt of similar remaining maturities and collateral terms.

Repurchase agreements Fair value approximates the carrying value of such liabilities due to their short-term nature.

Junior subordinated debentures The fair value for subordinated debentures is calculated using discounted cash flows based upon current market spreads to LIBOR for debt of similar remaining maturities and collateral terms.

Subordinated debt The fair value of the subordinated debt was estimated using either a discounted cash flow analysis based on current market interest rates for debt with similar maturities and credit quality or estimated using market quotes.

Accrued Interest Receivable and Payable The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Off-balance-sheet Instruments (Disclosed at Cost) Off-balance-sheet instruments are primarily comprised of loan commitments, which are generally priced at market at the time of funding. Fees on commitments to extend credit and stand-by letters of credit are deemed to be immaterial and these instruments are expected to be settled at face value or expire unused. It is impractical to assign any fair value to these instruments. At March 31, 2016, un-funded loan commitments totaled $116.9 million and stand-by letters of credit totaled $2.6 million. At December 31, 2015, un-funded loan commitments totaled $116.4 million and stand-by letters of credit totaled $3.2 million.