NOTE 7: FAIR VALUE OF FINANCIAL INSTRUMENTS

We record certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments are used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability.

Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The types of instruments valued based on quoted market prices in active markets include most U.S. government and Agency securities, liquid mortgage products, active listed equities and most money market securities. Such instruments are generally classified within Level 1 or Level 2 of the fair value hierarchy. We do not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, less liquid mortgage products, less liquid Agency securities, less liquid listed equities, state, municipal and provincial obligations, and certain physical commodities. Such instruments are generally classified within Level 2 of the fair value hierarchy.

Level 3 is for positions that are not traded in active markets or are subject to transfer restrictions; valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, Management’s best estimate will be used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Subsequent to inception, Management only changes Level 3 inputs and assumptions when corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt markets, and changes in financial ratios or cash flows.

Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at March 31, 2017 measured at fair value on a recurring basis:


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	10,164	$	—	$	10,164	$	—
U.S. GSEs		83,512		—		83,512		—
FHLB Obligations		67,050		—		67,050		—
Agency MBSs		64,277		—		64,277		—
Agency CMBSs		23,370		—		23,370		—
Agency CMOs		39,616		—		39,616		—
Interest rate swap agreements		973		—		973		—
Total assets	$	288,962	$	—	$	288,962	$	—
Liabilities
Interest rate swap agreements		774		—		774		—
Total liabilities	$	774	$	—	$	774	$	—

The table below presents the balance of financial assets and liabilities at December 31, 2016 measured at fair value on a recurring basis:


			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	25,183	$	—	$	25,183	$	—
U.S. GSEs		93,353		—		93,353		—
FHLB Obligations		67,006		—		67,006		—
Agency MBSs		75,209		—		75,209		—
Agency CMBSs		23,608		—		23,608		—
Agency CMOs		49,333		—		49,333		—
ABSs		306		—		306		—
Interest rate swap agreements		422		—		422		—
Total assets	$	334,420	$	—	$	334,420	$	—
Liabilities
Interest rate swap agreements		194		—		194		—
Total liabilities	$	194	$	—	$	194	$	—

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. More information regarding our investment securities can be found in Note 4 to these consolidated financial statements.

The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor. The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2017 or 2016. There were no Level 3 assets measured at fair value on a recurring basis at March 31, 2017 or December 31, 2016.

Financial instruments on a non-recurring basis

Certain financial assets are also measured at fair value on a non-recurring basis, however they were not material at March 31, 2017 or December 31, 2016. These financial assets include impaired loans and other real estate owned (“OREO”).

Fair value of financial instruments

The fair value of Merchants’ financial instruments as of March 31, 2017 are summarized in the table below:


	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	59,762	$	59,762	$	59,762	$	—	$	—
Securities available for sale		287,989		287,989		—		287,989		—
Securities held to maturity		80,991		81,088		—		81,088		—
FHLB stock		7,044		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,529,531		1,511,073		—		—		1,511,073
Interest rate swap agreement		973		973		—		973		—
Accrued interest receivable		5,085		5,085		—		1,096		3,989
Total	$	1,971,375	$	1,945,970	$	59,762	$	371,146	$	1,515,062
Deposits	$	1,511,676	$	1,510,694	$	1,321,166	$	189,528	$	—
Short-term borrowings		75,000		75,000		—		75,000		—
Securities sold under agreement to repurchase		249,582		249,651		—		249,651		—
Other long-term debt		3,630		3,585		—		3,585		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,721		—		14,721		—
Interest rate swap agreement		774		774		—		774		—
Accrued interest payable		123		123		11		112		—
Total	$	1,861,404	$	1,854,548	$	1,321,177	$	533,371	$	—

The fair value of Merchants’ financial instruments as of December 31, 2016 are summarized in the table below:


	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	82,953	$	82,953	$	82,953	$	—	$	—
Securities available for sale		333,998		333,998		—		333,998		—
Securities held to maturity		85,694		85,749		—		85,749		—
FHLB stock		4,976		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,501,550		1,484,718		—		—		1,484,718
Interest rate swap agreement		422		422		—		422		—
Accrued interest receivable		4,722		4,722		—		1,232		3,490
Total	$	2,014,315	$	1,992,562	$	82,953	$	421,401	$	1,488,208
Deposits	$	1,527,470	$	1,526,626	$	1,328,262	$	198,364	$	—
Short-term borrowings		40,000		40,000		—		40,000		—
Securities sold under agreement to repurchase		312,118		312,019		—		312,019		—
Other long-term debt		3,651		3,600		—		3,600		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,775		—		14,775		—
Interest rate swap agreement		194		194		—		194		—
Accrued interest payable		110		110		11		99		—
Total	$	1,904,162	$	1,897,324	$	1,328,273	$	569,051	$	—

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accrued interest receivable and accrued interest payable approximate fair value. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

The methodologies for other financial assets and financial liabilities are discussed below.

Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 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.

Deposits - The fair value of deposits with no stated maturity, which includes demand, savings, interest bearing checking and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities resulting in a Level 2 classification.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity resulting in a Level 2 classification.

Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is not material as of March 31, 2017 and December 31, 2016.