FAIR VALUE

12 Months Ended

Dec. 31, 2020

FAIR VALUE

FAIR VALUE

NOTE 5 – 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:

Securities:  Securities available-for-sale are valued primarily by a third party pricing service. The fair values of securities available-for-sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or pricing models which utilize significant observable inputs such as matrix pricing. This 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 (Level 2 inputs). These models utilize the market approach with standard inputs that include, but are not limited to benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. For certain municipal securities that are not rated and observable inputs about the specific issuer are not available, fair values are estimated using observable data from other municipal securities presumed to be similar or other market data on other non-rated municipal securities (Level 3 inputs).

The Company’s Finance Department, which is responsible for all accounting and SEC compliance, and the Company’s Treasury Department, which is responsible for investment portfolio management and asset/liability modeling, are the two areas that determine the Company’s valuation policies and procedures. Both of these areas report directly to the Executive Vice President and Chief Financial Officer of the Company. For assets or liabilities that may be considered for Level 3 fair value measurement on a recurring basis, these two departments and the Executive Vice President and Chief Financial Officer determine the appropriate level of the assets or liabilities under consideration. If there are assets or liabilities that are determined to be Level 3 by this group, the Risk Management Committee of the Company and the Audit Committee of the board of directors (the “Board”) are made aware of such assets at their next scheduled meeting.

Securities pricing is obtained on securities from a third party pricing service and all security prices are tested annually against prices from another third party provider and reviewed with a market value price tolerance variance that varies by sector: municipal securities +/- 5%, government agency/mbs/cmo +/-3% and U.S. treasuries +/-1%. If any securities fall outside the tolerance threshold and have a variance of $100,000 or more, a determination of materiality is made for the amount over the threshold. Any security that would have a material threshold difference would be further investigated to determine why the variance exists and if any action is needed concerning the security pricing for that individual security. Changes in market value are reviewed monthly in aggregate by security type and any material differences are reviewed to determine why they exist. At least annually, the pricing methodology of the pricing service is received and reviewed to support the fair value levels used by the Company. A detailed pricing evaluation is requested and reviewed on any security determined to be fair valued using unobservable inputs by the pricing service.

Mortgage banking derivative: The fair values of mortgage banking derivatives are based on observable market data as of the measurement date (Level 2).

NOTE 5 – FAIR VALUE (continued)

Interest rate swap derivatives: Our derivatives are traded in an over-the-counter market where quoted market prices are not always available. Therefore, the fair values of derivatives are determined using quantitative models that utilize multiple market inputs. The inputs will vary based on the type of derivative, but could include interest rates, prices and indices to generate continuous yield or pricing curves, prepayment rates, and volatility factors to value the position. The majority of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services. The fair value of interest rate swap derivatives is determined by pricing or valuation models using observable market data as of the measurement date (Level 2).

Impaired loans: Impaired loans with specific allocations of the allowance for loan losses are generally based on the fair value of the underlying collateral if repayment is expected solely from the collateral. Fair value is determined using several methods. Generally, the fair value of real estate is based on appraisals by qualified third party appraisers. 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. Such adjustments are usually significant and result in a Level 3 classification of the inputs for determining fair value. In addition, the Company’s management routinely applies internal discount factors to the value of appraisals used in the fair value evaluation of impaired loans. The deductions to the appraisals take into account changing business factors and market conditions, as well as value impairment in cases where the appraisal date predates a likely change in market conditions. Commercial real estate is generally discounted from its appraised value by 30-70% with the higher discounts applied to real estate that is determined to have a thin trading market or to be specialized collateral. In addition to real estate, the Company’s management evaluates other types of collateral as follows: (a) inventory is generally discounted from its cost or book value by 25-75%, depending on the marketability of the goods and ease of transportation; (b) accounts receivable are generally discounted by 40-100% depending on type of receivable, age of valuation, or other estimates of collectability; (c) equipment is valued at a percentage of depreciated book value or recent appraised value, if available, and is typically discounted at 30-100% after various considerations including age and condition of the equipment, marketability, breadth of use, and whether the equipment includes unique components or add-ons. This methodology is based on a market approach and typically results in a Level 3 classification of the inputs for determining fair value.

Mortgage servicing rights:  As of December 31, 2020, the fair value of the Company’s Level 3 servicing assets for residential mortgage loans (“MSRs”) was $4.2 million, carried at amortized cost less $715,000 in a valuation reserve, or $3.5 million. These residential mortgage loans have a weighted average interest rate of 3.7%, a weighted average maturity of 20 years and are secured by homes generally within the Company’s market area of Northern Indiana and Indianapolis. A valuation model is used to estimate fair value by stratifying the portfolios on the basis of certain risk characteristics, including loan type and interest rate. Impairment is estimated based on an income approach. The inputs used include estimates of prepayment speeds, discount rate, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, late fees, and float income. The most significant assumption used to value MSRs is prepayment rate. Prepayment rates are estimated based on published industry consensus prepayment rates. The most significant unobservable assumption is the discount rate. At December 31, 2020, the constant prepayment speed (“PSA”) used was 204 and discount rate used was 9.4%. At December 31, 2019, the PSA used was 118 and the discount rate used was 9.4%.

At December 31, 2020, the sensitivity of the current fair value of MSRs to an immediate 10% and 20% adverse change in the PSA and discount rate was ($146,000) and ($285,000), respectively for the PSA, and was ($115,000) and ($224,000), respectively for the discount rate. These sensitivities are hypothetical and should not be relied upon. As the figures indicate, changes in value based on a 10% and 20% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in value may not be linear. Also, in this example, the effect of a variation in a particular assumption on the value of the MSR is calculated without changing any other assumption; however, in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments), which might magnify or counteract the sensitivities.

NOTE 5 – FAIR VALUE (continued)

Other real estate owned:  Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are reviewed by the Company’s internal appraisal officer. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable properties used to determine value. Such adjustments are usually significant and result in a Level 3 classification. In addition, the Company’s management may apply discount factors to the appraisals to take into account changing business factors and market conditions, as well as value impairment in cases where the appraisal date predates a likely change in market conditions. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Real estate mortgage loans held-for-sale:  Real estate mortgage loans held for sale are carried at the lower of cost or fair value, as determined by outstanding commitments, from third party investors, and result in a Level 2 classification.

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis:

	December 31, 2020
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets:
U.S. government sponsored agency securities	$	—	$	36,487	$	—	$	36,487
Mortgage-backed securities: residential		—		279,503		—		279,503
Mortgage-backed securities: commercial		—		36,881		—		36,881
State and municipal securities		—		381,834		140		381,974
Total Securities		—		734,705		140		734,845
Mortgage banking derivative		—		1,182		—		1,182
Interest rate swap derivative		—		21,764		—		21,764
Total assets	$	—	$	757,651	$	140	$	757,791
Liabilities:
Mortgage banking derivative		—		111		—		111
Interest rate swap derivative		—		21,794		—		21,794
Total liabilities	$	—	$	21,905	$	—	$	21,905

	December 31, 2019
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets:
Mortgage-backed securities: residential	$	—	$	288,181	$	—	$	288,181
Mortgage-backed securities: commercial		—		36,972		—		36,972
State and municipal securities		—		282,935		145		283,080
Total Securities		—		608,088		145		608,233
Mortgage banking derivative		—		198		—		198
Interest rate swap derivative		—		7,263		—		7,263
Total assets	$	—	$	615,549	$	145	$	615,694
Liabilities:
Mortgage banking derivative		—		14		—		14
Interest rate swap derivative		—		7,860		—		7,860
Total liabilities	$	—	$	7,874	$	—	$	7,874

NOTE 5 – FAIR VALUE (continued)

The fair value of Level 3 available-for-sale securities was immaterial to warrant additional recurring fair value disclosures as of December 31, 2020 and 2019.

The tables below present the amount of assets measured at fair value on a nonrecurring basis:

	December 31, 2020
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	—	$	—	$	178	$	178
Non-working capital loans		—		—		4,904		4,904
Commercial real estate and multi-family residential loans:
Owner occupied loans		—		—		1,211		1,211
Agri-business and agricultural loans:
Loans secured by farmland		—		—		61		61
Consumer 1‑4 family mortgage loans:
Closed end first mortgage loans		—		—		411		411
Total impaired loans	$	—	$	—	$	6,765	$	6,765
Other real estate owned		—		—		0		—
Total assets	$	—	$	—	$	6,765	$	6,765

	December 31, 2019
	Fair Value Measurements Using						Assets
(dollars in thousands)	Level 1		Level 2		Level 3		at Fair Value
Assets
Impaired loans:
Commercial and industrial loans:
Working capital lines of credit loans	$	—	$	—	$	3,125	$	3,125
Non-working capital loans		—		—		6,374		6,374
Commercial real estate and multi-family residential loans:
Construction and land development loans		—		—		43		43
Owner occupied loans		—		—		1,450		1,450
Agri-business and agricultural loans:
Loans secured by farmland		—		—		57		57
Consumer 1‑4 family mortgage loans:
Closed end first mortgage loans		—		—		474		474
Open end and junior lien loans		—		—		587		587
Other consumer loans		—		—		11		11
Total impaired loans	$	—	$	—	$	12,121	$	12,121
Other real estate owned		—		—		—		—
Total assets	$	—	$	—	$	12,121	$	12,121

NOTE 5 – FAIR VALUE (continued)

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at December 31, 2020:

(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Average		Range of Inputs
Impaired loans:
Commercial and industrial	$	5,082	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	55	%	16%-100%
Impaired loans:
Commercial real estate		1,211	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	53	%	21%-74%
Impaired loans:
Agribusiness and agricultural		61	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	58	%
Impaired loans:
Consumer 1-4 family mortgage		411	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	11	%	10%-15%

NOTE 5 – FAIR VALUE (continued)

The following table presents the valuation methodology and unobservable inputs for Level 3 assets measured at fair value on a non-recurring basis at December 31, 2019:

(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Average		Range of Inputs
Impaired loans:
Commercial and industrial	$	9,499	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	53	%	1%-100%
Impaired loans:
Commercial real estate		1,493	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	27	%	7%-61%
Impaired loans:
Agribusiness and agricultural		57	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	61	%
Impaired loans:
Consumer 1-4 family mortgage		1,061	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	14	%	5%-100%
Impaired loans:
Other consumer		11	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	36	%

NOTE 5 – FAIR VALUE (continued)

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $14.6 million, with a valuation allowance of $7.8 million at December 31, 2020, resulting in an increase in provision for loan losses of $2.3 million for the year ended December 31, 2020. At December 31, 2019, impaired loans had a gross carrying amount of $22.2 million, with a valuation allowance of $10.1 million, resulting in an increase in provision for loan losses of $600,000 for the year ended December 31, 2019.

At December 31, 2020 and 2019, other real estate owned had a net carrying amount of $316,000.

The following table contains the estimated fair values and the related carrying values of the Company’s financial instruments at December 31, 2020. Items which are not financial instruments are not included.

	December 31, 2020
	Carrying		Estimated Fair Value
(dollars in thousands)	Value		Level 1		Level 2		Level 3		Total
Financial Assets:
Cash and cash equivalents	$	249,927	$	247,228	$	2,699	$	—	$	249,927
Securities available-for-sale		734,845		—		734,705		140		734,845
Real estate mortgages held-for-sale		11,218		—		11,651		—		11,651
Loans, net		4,587,748		—		—		4,532,639		4,532,639
Mortgage banking derivative		1,182		—		1,182		—		1,182
Interest rate swap derivative		21,764		—		21,764		—		21,764
Federal Reserve and Federal Home Loan Bank Stock		13,772		N/A		N/A		N/A		N/A
Accrued interest receivable		18,761		—		3,801		14,960		18,761
Financial Liabilities:
Certificates of deposit		(1,024,819)		—		(1,033,095)		—		(1,033,095)
All other deposits		(4,011,986)		(4,011,986)		—		—		(4,011,986)
Miscellaneous borrowings		(10,500)		—		(10,500)		—		(10,500)
Federal Home Loan Bank advances		(75,000)		—		(68,967)		—		(68,967)
Mortgage banking derivative		(111)		—		(111)		—		(111)
Interest rate swap derivative		(21,794)		—		(21,794)		—		(21,794)
Standby letters of credit		(686)		—		—		(686)		(686)
Accrued interest payable		(5,959)		(66)		(5,893)		—		(5,959)

NOTE 5 – FAIR VALUE (continued)

The following table contains the estimated fair values and the related carrying values of the Company’s financial instruments at December 31, 2019. Items which are not financial instruments are not included.

	December 31, 2019
	Carrying		Estimated Fair Value
(dollars in thousands)	Value		Level 1		Level 2		Level 3		Total
Financial Assets:
Cash and cash equivalents	$	99,381	$	96,603	$	2,778	$	—	$	99,381
Securities available-for-sale		608,233		—		608,088		145		608,233
Real estate mortgages held-for-sale		4,527		—		4,614		—		4,614
Loans, net		4,015,176		—		—		3,979,006		3,979,006
Mortgage banking derivative		198		—		198		—		198
Interest rate swap derivative		7,263		—		7,263		—		7,263
Federal Reserve and Federal Home Loan Bank Stock		13,772		N/A		N/A		N/A		N/A
Accrued interest receivable		15,391		—		3,729		11,662		15,391
Financial Liabilities:
Certificates of deposit		(1,192,067)		—		(1,202,060)		—		(1,202,060)
All other deposits		(2,941,752)		(2,941,752)		—		—		(2,941,752)
Federal Home Loan Bank advances		(170,000)		—		(169,998)		—		(169,998)
Mortgage banking derivative		(14)		—		(14)		—		(14)
Interest rate swap derivative		(7,860)		—		(7,860)		—		(7,860)
Standby letters of credit		(915)		—		—		(915)		(915)
Accrued interest payable		(11,604)		(102)		(11,502)		—		(11,604)