NOTE 8 — FAIR VALUE

ASC 820 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

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 reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or using market data utilizing pricing models, primarily Interactive Data Corporation (IDC), that vary based upon asset class and include available trade, bid, and other market information. Matrix pricing is used for most municipals, 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 securities’ relationship to other benchmark quoted securities. The grouping of securities is done according to insurer, credit support, state of issuance, and rating to incorporate additional spreads and municipal curves. For the general market municipals, the Thomson Municipal Market Data curve is used to determine the initial curve for determining the price, movement, and yield relationships with the municipal market (Level 2 inputs). Level 3 securities are largely comprised of small, local municipality issuances. Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available. Twice a year, a sample of prices supplied by the pricing agent is validated by comparison to prices obtained from other third party sources.

The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals or industry accepted valuation methods. In a limited number of situations, the Company’s appraisal department is determining the value of 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 loan officers to adjust for differences between the comparable sales and income data available as well as costs to sell. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. Impaired loans are evaluated quarterly for additional impairment and take into account changing market conditions, specific information in the market the property is located, and the overall economic climate as well as overall changes in the credit. The Company’s Appraisal Manager has the overall responsibility for all appraisals. The Company’s loan officer responsible for the loan, the special assets officer, as well as the senior officers of the Company review the adjustments made to the appraisal for market and disposal costs on the loan.

The fair value of other real estate owned is measured based on the value of the collateral securing those assets and is determined using several methods. The fair value of real estate is generally determined based on appraisals by qualified licensed appraisers (third party). The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis. Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Appraisal 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 values are reviewed on at least an annual basis. The Company normally applies an internal discount to the value of appraisals used in the fair value evaluation of OREO. The deductions take into account changing business factors and market conditions as well as disposal costs. As noted in the impaired loans discussion above, the Company’s Appraisal Manager has the overall responsibility for all appraisals. The Appraisal Manager reports to the Vice President of Credit Administration who reports to the Chief Credit Officer of the Company.

The fair value of servicing rights is based on a valuation model from a third party that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 3 inputs).

The fair value of mortgage banking derivatives are based on derivative valuation models using market data inputs as of the valuation date (Level 2). The mortgage banking derivative is classified as Interest receivable and other assets on the balance sheet.

The fair value of interest rate swaps are based on valuation models using observable market data as of the measurement date (Level 2). The fair value of derivatives are classified as Interest receivable and other assets and Other liabilities on the balance sheet.

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value under ASC 820 on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:


			Fair Value Measurements at September 30, 2016 Using:
			Quoted Prices in		Significant		Significant
			Active Markets for		Other Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Investment securities available-for-sale
U. S. government agency	$	436	$	—	$	436	$	—
States and municipal		359,697		—		349,443		10,254
Mortgage-backed securities — residential — Government Sponsored Entity		456,464		—		456,464		—
Collateralized mortgage obligations — Government Sponsored Entity		195,619		—		195,619		—
Equity securities		6,233		6,233		—		—
Other securities		6,599		—		—		6,599
Total investment securities available-for-sale	$	1,025,048	$	6,233	$	1,001,962	$	16,853

Mortgage banking derivatives	$	1,057		—	$	1,057		—

Interest rate swap asset	$	6,255		—	$	6,255		—
Interest rate swap liability	$	(6,255)		—	$	(6,255)		—


			Fair Value Measurements at December 31, 2015 Using:
			Quoted Prices in		Significant		Significant
			Active Markets for		Other Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Investment securities available-for-sale
U. S. government agency	$	504	$	—	$	504	$	—
States and municipal		350,733		—		339,875		10,858
Mortgage-backed securities — residential — Government Sponsored Entity		334,080		—		334,080		—
Collateralized mortgage obligations — Government Sponsored Entity		228,749		—		228,749		—
Equity securities		4,689		4,689		—		—
Other securities		6,524		—		—		6,524
Total investment securities available-for-sale	$	925,279	$	4,689	$	903,208	$	17,382

Mortgage banking derivative	$	700		—	$	700		—

Interest rate swap asset	$	1,508		—	$	1,508		—
Interest rate swap liability	$	(1,508)		—	$	(1,508)		—

There were no transfers between Level 1 and Level 2 during the third quarter of 2016 or 2015.

The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine month periods ended September 30, 2016 and 2015:

Three months ended September 30:


States and municipal	2016		2015
Beginning balance, July 1	$	10,430	$	11,863
Total gains or losses (realized / unrealized)
Included in other comprehensive income		6		(6)
Settlements		(182)		(510)
Ending balance, September 30	$	10,254	$	11,347


Other securities	2016		2015
Beginning balance, July 1	$	6,601	$	2,527
Total gains or losses (realized / unrealized)
Purchases		—		—
Included in other comprehensive income		(2)		(2)
Ending balance, September 30	$	6,599	$	2,525

Nine months ended September 30:


States and municipal	2016		2015
Beginning balance, January 1	$	10,858	$	12,810
Total gains or losses (realized / unrealized)
Included in other comprehensive income		8		(36)
Settlements		(612)		(1,427)
Ending balance, September 30	$	10,254	$	11,347


Other securities	2016		2015
Beginning balance, January 1	$	6,524	$	2,503
Total gains or losses (realized / unrealized)
Purchases				—
Included in other comprehensive income		75		22
Ending balance, September 30	$	6,599	$	2,525

The Company’s state and municipal security valuations were supported by analysis prepared by an independent third party. Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

The Company’s other security valuation was supported by analysis prepared by an independent third party. Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers. In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

Assets and Liabilities Measured on a Non-Recurring Basis

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


			Fair Value Measurements at September 30, 2016 Using:
			Quoted Prices in	Significant	Significant
			Active Markets for	Other Observable	Unobservable
	September 30,		Identical Assets	Inputs	Inputs
	2016		(Level 1)	(Level 2)	(Level 3)
Assets:
Impaired loans
Commercial and industrial	$	259			$	259
Agricultural		1,081				1,081
Farm real estate		823				823
Other real estate		588				588
Total impaired loans	$	2,751			$	2,751

Impaired servicing rights	$	3,161			$	3,161


			Fair Value Measurements at December 31, 2015 Using:
			Quoted Prices in	Significant	Significant
			Active Markets for	Other Observable	Unobservable
	December 31,		Identical Assets	Inputs	Inputs
	2015		(Level 1)	(Level 2)	(Level 3)
Assets:
Impaired loans
Commercial and industrial	$	58			$	58
Other real estate		1,082				1,082
Total impaired loans	$	1,140			$	1,140

Impaired servicing rights	$	531			$	531

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $3,700, with a valuation allowance of $949 at September 30, 2016. The Company recorded a charge of $228 to provision expense associated with these loans for the three months ended September 30, 2016 and a charge of $634 to provision expense with these loans for the nine month period ending September 30, 2016. The Company recorded a charge of $426 to provision expense associated with these loans for the three months ended September 30, 2015 and a charge of $1,281 provision expense associated with these loans for the nine month period ending September 30, 2015. At December 31, 2015, impaired loans had a gross carrying amount of $2,393 with a valuation allowance of $1,253. A breakdown of these loans by portfolio class at September 30, 2016 is as follows:


	Gross		Valuation
	Balance		Allowance		Net
Commercial and industrial	$	344	$	85	$	259
Agricultural		1,450		369		1,081
Farm real estate		1,105		282		823
Other real estate		801		213		588
Ending Balance	$	3,700	$	949	$	2,751

Impaired tranches of servicing rights were carried at a fair value of $3,161, which is made up of the gross outstanding balance of $3,536 net of a valuation allowance of $375. A $125 charge was made to the valuation allowance in the third quarter of 2016 and a charge of $175 was made to the valuation account in the first nine months of 2016. A $25 credit to earnings was made to the valuation allowance in the third quarter of 2015 and a credit of $175 was made to the valuation allowance in the first nine months of 2015. At December 31, 2015, impaired servicing rights were carried at a fair value of $531 which was made up of the gross outstanding balance of $731, net of a valuation allowance of $200.

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2016 and December 31, 2015. Impaired commercial loans, commercial real estate loans, and other real estate owned that are deemed collateral dependent are valued based on the fair value of the underlying collateral. These estimates are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property and other related factors to estimate the current value of the collateral. The fair value of the mortgage servicing rights is valued based on present value of future cash flows to be received taking into account the coupon rate on the mortgage as well as estimated prepayment speeds.

Fair Value

Valuation

Unobservable

Range/

September 30, 2016

(in thousands)

Technique(s)

Input(s)

Average

Impaired Loans:

Commercial and industrial

259

Sales comparison approach

Adjustment for differences between comparable sales

15% - 25%

21% Avg

Agricultural

1,081

Sales comparison approach

Adjustment for differences between comparable sales

10%

10% Avg

Farm real estate

823

Sales comparison approach

Adjustment for differences between comparable sales

10%

10% Avg

Other real estate

588

Sales comparison approach

Adjustment for differences between comparable sales, type of property, current status of property

15% - 25%

20% Avg

2,751

Mortgage servicing rights

3,161

Cash flow analysis

Discount rate

10%

Fair Value

Valuation

Unobservable

Range/

December 31, 2015

(in thousands)

Technique(s)

Input(s)

Average

Impaired Loans:

Farm real estate

Sales comparison approach

Adjustment for differences between comparable sales

10%

10% Avg

Other

1,082

Sales comparison approach

Adjustment for differences between comparable sales, type of property, current status of property

0% - 20%

1,140

10% Avg

Mortgage servicing rights

531

Cash flow analysis

Discount rate

10%

The carrying amounts and estimated fair values of financial instruments, not previously presented, is as follows:


	Carrying
September 30, 2016	Amount		Level 1		Level 2		Level 3		Total
Assets
Cash and cash equivalents	$	80,329	$	62,809	$	17,520	$		$	80,329
Interest bearing time deposits		1,960				1,960				1,960
Loans including loans held for sale, net		2,567,304				7,222		2,638,678		2,645,900
FHLB and other stock		21,537								N/A
Interest receivable		11,995				5,084		6,911		11,995
Liabilities
Deposits		(3,124,028)		(705,428)		(2,418,500)				(3,123,928)
Other borrowings		(108,076)				(118,876)				(118,876)
FHLB advances		(259,638)				(263,694)				(263,694)
Interest payable		(669)				(669)				(669)
Subordinated debentures		(41,239)				(24,212)				(24,212)


	Carrying
December 31, 2015	Amount		Level 1		Level 2		Level 3		Total
Assets
Cash and cash equivalents	$	67,578	$	56,104	$	11,474	$		$	67,578
Interest bearing time deposits		1,960				1,960				1,960
Loans including loans held for sale, net		2,139,765				7,726		2,187,366		2,195,092
FHLB and other stock		11,300								N/A
Interest receivable		10,779				4,901		5,878		10,779
Liabilities
Deposits		(2,650,775)		(641,439)		(2,007,405)				(2,648,844)
Other borrowings		(28,363)				(28,363)				(28,363)
FHLB advances		(269,488)				(270,977)				(270,977)
Interest payable		(560)				(560)				(560)
Subordinated debentures		(41,239)				(24,212)				(24,212)

The difference between the loan balance included above and the amounts shown in Note 4 are the impaired loans discussed above.

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

(a) Cash and Cash Equivalents

The carrying amounts of cash, short-term instruments, and interest bearing time deposits approximate fair values and are classified as either Level 1 or Level 2. Noninterest bearing deposits are Level 1 whereas interest bearing, due from bank accounts, and fed funds sold are Level 2.

(b) FHLB and other stock

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

Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(d) Deposits

The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in a Level 1 classification. Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(e) Borrowings

The fair values of the Company’s FHLB advances are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s Other borrowings are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

(f) Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.