9. FAIR VALUE MEASUREMENTS AND DISCLOSURES

Financial Accounting Standards Board (FASB) ASC 820,

Fair Value Measurements and Disclosures

, defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (fair values are not adjusted for transaction costs). ASC 820 also establishes a framework (fair value hierarchy) for measuring fair value under GAAP, and expands disclosures about fair value measurements.

ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods 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 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:

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 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 with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The measurement of fair value should be consistent with one of the following valuation techniques: market approach, income approach, and/or cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the security’s relationship to other benchmark quoted securities.

The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis and the fair value measurements by level within the fair value hierarchy as of June 30, 2016:



June 30, 2016	Quoted prices in active markets for identical assets (Level 1)		Significant other observable input (Level 2)		Significant unobservable inputs (Level 3)		Balance at end of period
Recurring fair value measurements
Trading Securities
State and municipal securities		-	$	3,459		-	$	3,459

Securities available-for-sale
U.S. Government agency securities		-		60,510		-		60,510
State and municipal securities		-		73,888		-		73,888
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		-		129,027		-		129,027
Collateralized mortgage obligations (CMOs)		-		62,545		-		62,545
Pooled trust preferred securities		-		-	$	2,400		2,400
Corporate debt securities		-		8,110		-		8,110
Equity securities	$	7,773		-		-		7,773
Total securities available-for-sale	$	7,773	$	334,080	$	2,400	$	344,253
Total recurring fair value measurements	$	7,773	$	337,539	$	2,400	$	347,712

Nonrecurring fair value measurements *
Impaired loans	$	-	$	-	$	1,962	$	1,962
Mortgage servicing rights		-		-		45		45
Total nonrecurring fair value measurements	$	-	$	-	$	2,007	$	2,007

* impairment

There were no transfers in and out of Level 1 and Level 2 fair value measurements during the six months ended June 30, 2016. There were also no transfers in or out of level 3 for the same period. There were no losses included in earnings attributable to the change in unrealized gains or losses relating to the available-for-sale securities above with fair value measurements utilizing significant unobservable inputs for the six-month period ended June 30, 2016.

The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy as of December 31, 2015:



December 31, 2015	Quoted prices in active markets for identical assets (Level 1)		Significant other observable input (Level 2)		Significant unobservable inputs (Level 3)		Balance at end of period
Recurring fair value measurements
Trading Securities
State and municipal securities		-	$	4,189		-	$	4,189

Securities available-for-sale
U.S. Government agency securities		-		61,779		-		61,779
State and municipal securities		-		78,954		-		78,954
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		-		136,681		-		136,681
Collateralized mortgage obligations (CMOs)		-		65,610		-		65,610
Pooled trust preferred securities		-		-	$	2,653		2,653
Corporate debt securities		-		9,004		-		9,004
Equity securities	$	7,234		-		-		7,234
Total securities available-for-sale	$	7,234	$	352,028	$	2,653	$	361,915
Total recurring fair value measurements	$	7,234	$	356,217	$	2,653	$	366,104

Nonrecurring fair value measurements *
Impaired loans	$	-	$	-	$	1,698	$	1,698
Mortgage servicing rights		-		-		133		133
Total nonrecurring fair value measurements	$	-	$	-	$	1,831	$	1,831

* impairment

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

Quantitative information about Level 3 fair value measurements

June 30, 2016

Fair value

Valuation

techniques

Unobservable

input

Value or range

of values

Impaired loans

972

Appraisal of collateral (1)

Appraisal adjustments (2)

-10%

-70%

Liquidation expenses (3)

-10%

Impaired loans

115

Used commercial vehicle and equipment guides

Guide value discounts (4)

-40%

Impaired loans

125

Financial statement values for UCC collateral

Financial statement value discounts (5)

-25%

Impaired loans

750

Agreement of

sale (6)

Mortgage servicing rights

Discounted cash flow

Remaining term

27yrs

Discount rate

10%

12%

Quantitative information about Level 3 fair value measurements

December 31, 2015

Fair value

Valuation

techniques

Unobservable

input

Value or range

of values

Impaired loans

1,331

Appraisal of collateral (1)

Appraisal adjustmen

ts (2)

-15%

-80%

Liquidation expenses (3)

-10%

Impaired loans

199

Used commercial vehicle and equipment guides

Guide value discounts (4)

-30%

Impaired loans

168

Financial statement values for UCC collateral

Financial statement value discounts (5)

-25%

-70%

Mortgage servicing rights

133

Discounted

cash flow

Remaining term

28yrs

Discount rate

10%

12%

(1)	Fair value is primarily determined through appraisals of the underlying collateral by independent parties, which generally include various level 3 inputs which are not always identifiable.
(2)	Appraisals may be adjusted by management for qualitative factors such as economic conditions and the age of the appraisal. The range is presented as a percent of the initial appraised value.
(3)	Appraisals and pending agreements of sale are adjusted by management for estimated liquidation expenses. The range is presented as a percent of the initial appraised value.
(4)	If lendable value (lower than wholesale) is utilized then no additional discounts are taken. If lendable value is not provided then additional discounts are applied.
(5)	Values obtained from financial statements for UCC collateral (fixed assets and inventory) are discounted to estimated realizable liquidation value.
(6)	Fair value is determined by the estimated net proceeds.

The following table presents additional information about the securities available-for-sale measured at fair value on a recurring basis and for which QNB utilized significant unobservable inputs (Level 3 inputs) to determine fair value for the six months ended June 30, 2016:

	Fair value measurements using significant unobservable inputs (Level 3)
Balance, January 1, 2016	$	2,653
Payments received		(197	)
Total gains or losses (realized/unrealized):
Included in earnings		-
Included in other comprehensive income (loss)		(56	)
Transfers in and/or out of Level 3		-
Balance, June 30, 2016	$	2,400

The Level 3 securities consist of six collateralized debt obligation securities, PreTSL securities, which are backed by trust preferred securities issued by banks, thrifts, and insurance companies. As discussed in Note 7, despite the fact that there were some trades over the past few years, the market for these securities at June 30, 2016 was not active and markets for similar securities also are not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which PreTSLs trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive and there are currently very few market participants who are willing and or able to transact for these securities.

Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:

●

The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at June 30, 2016;

●

An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and

●

PreTSLs will be classified within Level 3 of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date.

The Bank is aware of several factors indicating that recent transactions of PreTSL securities are not orderly including an increased spread between bid/ask prices, lower sales transaction volumes for these types of securities, and a lack of new issuances. As a result, the Bank engaged an independent third party to value the securities using a discounted cash flow analysis. The estimated cash flows are based on specific assumptions about defaults, deferrals and prepayments of the trust preferred securities underlying each PreTSL. The resulting collateral cash flows are allocated to the bond waterfall using the INTEXcalc valuation model. Default rates are calculated based upon a comparison of key financial ratios of active individual issuers without a short-term probability of default compared to all FDIC insured banks. The base loss severity assumption and long-term loss severity assumptions are modeled at 95%. The severity factor for near-term default is vectored to reflect the relative expected performance of the institutions modeled to default, with lower forecasted severities used for the higher quality institutions. Prepayments are modeled to take into account the disruption in the asset-backed securities marketplace and the lack of new pooled trust preferred issuances. For those institutions rated below investment grade the holding companies’ approximate cost of long-term funding given their rating and marketplace interest rate was estimated. The following assumption was made; any holding company that could refinance for a cost savings of more than 2% will refinance and will do so as soon as possible. Finally, for issuers not impacted by the Tier 1 regulatory capital legislation enacted by the Dodd-Frank Act, the issuers that have shown a recent history of prepayment of both floating rate and fixed rate issues were identified and it was assumed these issuers will prepay as soon as possible.

The internal rate of return is the pre-tax yield used to discount the best estimate of future cash flows after credit losses. The cash flows have been discounted using estimated market discount rates of 3-month LIBOR plus spreads ranging from 4.79% to 7.55%. The determination of appropriate market discount rates involved the consideration of the following:

●

the time value of money

●

the price for bearing uncertainty in cash flows

●

other factors that would be considered by market participants

The analysis of discount rates involved the review of corporate bond spreads for banks, U.S. Treasury yields, credit default swap rates for financial companies (utilized as a proxy for credit), the swap/LIBOR yield curve and the characteristics of the individual securities being valued. For a further discussion of PreTSL valuation, see Note 7, Investment Securities.

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of QNB’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between QNB’s disclosures and those of other companies may not be meaningful.

The following methods and assumptions were used to estimate the fair values of each major classification of financial instrument and non-financial asset at June 30, 2016 and December 31, 2015:

Cash and cash equivalents, accrued interest receivable and accrued interest payable (carried at cost)

: The carrying amounts reported in the balance sheet approximate those assets’ fair value.

Investment securities

- trading (carried at fair value),

available for sale (carried at fair value) and held-to-maturity (carried at amortized cost)

The fair value of securities are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. Level 2 debt securities are valued by a third-party pricing service commonly used in the banking industry. Level 2 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 date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. For certain securities which 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 (Level 3). In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Cash flow models using a present value formula that includes assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) were used to support fair values of certain Level 3 investments.

Restricted investment in bank stocks (carried at cost)

: The fair value of stock in Atlantic Community Bankers Bank and the Federal Home Loan Bank is the carrying amount, based on redemption provisions, and considers the limited marketability of such securities.

Loans Held

for

Sale (carried at lower of cost or fair value)

: The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted 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.

Loans Receivable (carried at cost)

: The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired Loans (generally carried at fair value)

: Impaired loans are loans, in which the Company 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. Included in the fair value of impaired loans at December 31, 2015 were $145,000 of loans that had no specific reserves required at year end; however, were partially charged-off at year end. There were no such loans at June 30, 2016.

Mortgage Servicing Rights (carried at lower of cost or fair value)

: The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The mortgage servicing rights are stratified into tranches based on predominant characteristics, such as interest rate, loan type and investor type. The valuation incorporates assumptions that market participants would use in estimating future net servicing income.

Foreclosed assets (other real estate owned and repossessed assets)

: Foreclosed assets are the only non-financial assets valued on a non-recurring basis which are held by the Company at fair value, less cost to sell. At foreclosure or repossession, if the fair value, less estimated costs to sell, of the collateral acquired (real estate, vehicles, equipment) is less than the Company’s recorded investment in the related loan, a write-down is recognized through a charge to the allowance for loan losses. Additionally, valuations are periodically performed by management and any subsequent reduction in value is recognized by a charge to income. The fair value of foreclosed assets held-for-sale is estimated using Level 2 inputs based on observable market data.

Deposit liabilities (carried at cost)

: The fair value of deposits with no stated maturity (e.g. demand deposits, interest-bearing demand accounts, money market accounts and savings accounts) are by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). This approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative

sources of funding. Deposits with a stated maturity (time deposits) have been valued using the present value of cash flows discounted at rates approximating the current market for similar deposits.

Short-term borrowings (carried at cost)

: The carrying amount of short-term borrowings approximates their fair values.

Off-balance-sheet instruments (disclosed at cost)

: The fair values for the Bank’s off-balance sheet instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in a sales transaction on the dates indicated. The estimated fair value amounts have been measured as of the respective period ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.

The estimated fair values and carrying amounts of the Company’s financial and off-balance sheet instruments are summarized as follows:

					Fair value measurements
June 30, 2016	Carrying amount		Fair value		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Financial assets
Cash and cash equivalents	$	57,949	$	57,949	$	57,949		-		-
Investment securities:
Trading		3,459		3,459		-	$	3,459		-
Available-for-sale		344,253		344,253		7,773		334,080	$	2,400
Held-to-maturity		147		149		-		149		-
Restricted investment in bank stocks		522		522		-		522		-
Loans held-for-sale		184		191		-		191		-
Net loans		596,928		607,603		-		-		607,603
Mortgage servicing rights		495		578		-		-		578
Accrued interest receivable		2,376		2,376		-		2,376		-

Financial liabilities
Deposits with no stated maturities	$	664,912	$	664,912	$	664,912		-	$	-
Deposits with stated maturities		228,373		231,803		-	$	231,803		-
Short-term borrowings		36,693		36,693		36,693		-		-
Accrued interest payable		330		330		-		330		-

Off-balance sheet instruments
Commitments to extend credit	$	-	$	-	$	-	$	-	$	-
Standby letters of credit		-		-		-		-		-

					Fair value measurements
December 31, 2015	Carrying amount		Fair value		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Financial assets
Cash and cash equivalents	$	16,991	$	16,991	$	16,991		-		-
Investment securities:
Trading		4,189		4,189		-	$	4,189		-
Available-for-sale		361,915		361,915		7,234		352,028	$	2,653
Held-to-maturity		147		151		-		151		-
Restricted investment in bank stocks		508		508		-		508		-
Loans held-for-sale		987		1,004		-		1,004		-
Net loans		607,716		610,315		-		-		610,315
Mortgage servicing rights		504		642		-		-		642
Accrued interest receivable		2,562		2,562		-		2,562		-

Financial liabilities
Deposits with no stated maturities	$	662,410	$	662,410	$	662,410		-	$	-
Deposits with stated maturities		227,376		227,862		-	$	227,862		-
Short-term borrowings		37,163		37,163		37,163		-		-
Accrued interest payable		330		330		-		330		-

Off-balance sheet instruments
Commitments to extend credit	$	-	$	-	$	-	$	-	$	-
Standby letters of credit		-		-		-		-		-