Note 17 - Fair Value Measurements and Fair Values of Financial Instruments

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.

For financial assets measured at fair value on a recurring and nonrecurring basis, the fair value measurements by level within the fair value hierarchy used were as follows:

December 31, 2017	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
Securities available-for-sale
U.S. Government agency securities		—	$	70,524		—	$	70,524
State and municipal securities		—		76,804		—		76,804
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		—		142,703		—		142,703
Collateralized mortgage obligations (CMOs)		—		76,302		—		76,302
Pooled trust preferred securities		—		—	$	215		215
Corporate debt securities		—		8,022		—		8,022
Equity securities	$	4,975		—		—		4,975
Total securities available-for-sale	$	4,975	$	374,355	$	215	$	379,545
Total recurring fair value measurements	$	4,975	$	374,355	$	215	$	379,545

Nonrecurring fair value measurements *
Impaired loans	$	—	$	—	$	1,067	$	1,067
Mortgage servicing rights		—		—		34		34
Total nonrecurring fair value measurements	$	—	$	—	$	1,101	$	1,101

*	impairment

December 31, 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	$	—	$	3,596	$	—	$	3,596

Securities available-for-sale
U.S. Government agency securities		—	$	76,650		—	$	76,650
State and municipal securities		—		72,295		—		72,295
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		—		145,301		—		145,301
Collateralized mortgage obligations (CMOs)		—		77,415		—		77,415
Pooled trust preferred securities		—		—	$	2,281		2,281
Corporate debt securities		—		8,030		—		8,030
Equity securities	$	8,503		—		—		8,503
Total securities available-for-sale	$	8,503	$	379,691	$	2,281	$	390,475
Total recurring fair value measurements	$	8,503	$	383,287	$	2,281	$	394,071

Nonrecurring fair value measurements *
Impaired loans	$	—	$	—	$	2,899	$	2,899
Mortgage servicing rights		—		—		58		58
Total nonrecurring fair value measurements	$	—	$	—	$	2,957	$	2,957

*	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

December 31, 2017

Fair value

Valuation

techniques

Unobservable

input

Value or range

of values

Impaired loans

943

Appraisal of collateral

(1)

Appraisal adjustments

(2)

-15% to -90%

Liquidation expenses

(3)

-10%

Impaired loans

124

Financial statement values for UCC collateral

Financial statement value discounts

(5)

-25% to -50%

Mortgage servicing rights

Discounted cash flow

Remaining term

2 - 26 yrs

Discount rate

13% to 15%

Quantitative information about Level 3 fair value measurements

December 31, 2016

Fair value

Valuation

techniques

Unobservable

input

Value or range

of values

Impaired loans

938

Appraisal of collateral

(1)

Appraisal adjustments

(2)

-10% to -80%

Liquidation expenses

(3)

-10%

Impaired loans

Used commercial vehicle and equipment guides

Guide value discounts

(4)

0% to -25%

Impaired loans

1,880

Financial statement values for UCC collateral

Financial statement value discounts

(5)

-20% to -50%

Impaired loans

Agreement of sale

(6)

Mortgage servicing rights

Discounted cash flow

Remaining term

2 - 27 yrs

Discount rate

14% to 16%

(1)	Fair value is primarily determined through appraisals of the underlying collateral by independent parties, which generally includes 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 net amount due.

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 year ended December 31:

	Fair value measurements using significant unobservable inputs (Level 3)
Securities available-for-sale	2017			2016
Balance, beginning of year	$	2,281		$	2,653
Payments received		(55	)		(381	)
Sale of securities		(2,026	)		—
Total gains or losses (realized/unrealized)
Included in earnings		(15	)		—
Included in other comprehensive income		30			9
Transfers in and/or out of Level 3		—			—
Balance, end of year	$	215		$	2,281

There were no transfers in and out of Level 1 and Level 2 fair value measurements during the years ended December 31, 2017 and 2016. There were also no transfers in or out of level 3 for the same periods. There was $15,000 and $0 in 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 years ended December 31, 2017 and 2016, respectively.

The Level 3 securities consist of one collateralized debt obligation security (“PreTSL”), which is backed by trust preferred securities issued by banks. As discussed in Note 4, despite the fact that there were some trades during 2017, the market for these securities at December 31, 2017 was not active and markets for similar securities also are not active. 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 December 31, 2017;

•

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 used an independent third party to value this security using a discounted cash flow analysis. Based on management’s review of the bond’s five underlying issuers, there are no expected credit losses or prepayments; cashflows used were contractual based on the Bloomberg YA screen. The assumed cashflows have been discounted using and estimated market discount rate based on the 30-year swap rate. The 30-year is used as the reference rate since it is indicative of market expectation for short-term rates in the future. This is consistent with the 30-year nature of PreTSL securities, which are priced using the 3-month LIBOR as a reference rate. The discount rate of 6% includes the risk-free rate, a credit component and a spread for illiquidity.

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 December 31, 2017 and 2016:

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. None of the impaired loans at December 31, 2017 or 2016, respectively, that had specific reserves required were partially charged-off at year end.

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.

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 value 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 year 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
December 31, 2017	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	$	16,331	$	16,331	$	16,331		—		—
Investment securities:
Trading		—		—		—		—		—
Available-for-sale		379,545		379,545		4,975	$	374,355	$	215
Restricted investment in bank stocks		1,501		1,501		—		1,501		—
Net loans		725,442		727,341		—		—		727,341
Mortgage servicing rights		483		585		—		—		585
Accrued interest receivable		3,545		3,545		—		3,545		—

Financial liabilities
Deposits with no stated maturities	$	768,766	$	768,766	$	768,766		—	$	—
Deposits with stated maturities		225,182		223,325		—	$	223,325		—
Short-term borrowings		55,756		55,756		55,756		—		—
Accrued interest payable		384		384		—		384		—

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

					Fair value measurements
December 31, 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	$	10,721	$	10,721	$	10,721		—		—
Investment securities:
Trading		3,596		3,596		—	$	3,596		—
Available-for-sale		390,475		390,475		8,503		379,691	$	2,281
Restricted investment in bank stocks		1,017		1,017		—		1,017		—
Loans held-for-sale		789		789		—		789		—
Net loans		625,685		626,052		—		—		626,052
Mortgage servicing rights		498		579		—		—		579
Accrued interest receivable		3,128		3,128		—		3,128		—

Financial liabilities
Deposits with no stated maturities	$	687,773	$	687,773	$	687,773		—	$	—
Deposits with stated maturities		225,582		225,403		—	$	225,403		—
Short-term borrowings		52,660		52,660		52,660		—		—
Accrued interest payable		335		335		—		335		—

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