23.Fair Value of Financial Instruments

The Corporation complies with the guidance of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. The Corporation also follows the guidance on matters relating to all financial instruments found in ASC Subtopic 825-10, Financial Instruments – Overall.

Fair value is defined as the price to sell an asset or to transfer a liability in an orderly transaction between willing market participants as of the measurement date. Fair value is best determined by values quoted through active trading markets. Active trading markets are characterized by numerous transactions of similar financial instruments between willing buyers and willing sellers. Because no active trading market exists for various types of financial instruments, many of the fair values disclosed were derived using present value discounted cash flows or other valuation techniques described below. As a result, the Corporation’s ability to actually realize these derived values cannot be assumed.

The Corporation measures fair values based on the fair value hierarchy established in ASC Paragraph 820-10-35-37. 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 inputs that may be used to measure fair value under the hierarchy are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities. This level is the most reliable source of valuation.

Level 2: Quoted prices that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability. Level 2 inputs include inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates). It also includes inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs). Several sources are utilized for valuing these assets, including a contracted valuation service, Standard & Poor’s (“S&P”) evaluations and pricing services, and other valuation matrices.

Level 3: Prices or valuation techniques that require inputs that are both significant to the valuation assumptions and not readily observable in the market (i.e. supported with little or no market activity). Level 3 instruments are valued based on the best available data, some of which is internally developed, and consider risk premiums that a market participant would require.

The level established within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Transfers in and out of Level 1, 2 or 3 are recorded at fair value at the beginning of the reporting period.

Management believes that the Corporation’s valuation techniques are appropriate and consistent with the techniques used by other market participants. However, the use of different methodologies and assumptions could result in a different estimate of fair values at the reporting date. The following valuation techniques were used to measure the fair value of assets in the table below which are measured on a recurring and non-recurring basis as of December 31, 2017.

Investments – The investment portfolio is classified and accounted for based on the guidance of ASC Topic 320, Investments – Debt and Equity Securities.

The fair value of investments available-for-sale is determined using a market approach. As of December 31, 2017, the U.S. Government agencies and treasuries, residential and commercial mortgage-backed securities, private label residential mortgage-backed securities, and municipal bonds segments are classified as Level 2 within the valuation hierarchy. Their fair values were determined based upon market-corroborated inputs and valuation matrices, which were obtained through third party data service providers or securities brokers through which we have historically transacted both purchases and sales of investment securities.

The CDO segment, which consists of pooled trust preferred securities issued by banks, thrifts and insurance companies, is classified as Level 3 within the valuation hierarchy. At December 31, 2017, the Corporation owned 10 pooled trust preferred securities with an amortized cost of $19.7 million and a fair value of $14.9 million. The market for these securities at December 31, 2017 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive, as few CDOs have been issued since 2007. There are currently very few market participants who are willing to effect transactions in these securities. The market values for these securities or any securities other than those issued or guaranteed by the Treasury are depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (i) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at December 31, 2017, (ii) an income valuation approach technique (i.e. present value) 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 a market approach, and (iii) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.

Management believes that the valuation of certain securities is a critical accounting policy that requires significant estimates in preparation of its consolidated financial statements. Management utilizes an independent third party to prepare both the impairment valuations and fair value determinations for its CDO portfolio consisting of pooled trust preferred securities. Management performs due diligence on the third-party processes and believes that it has an adequate understanding of the analysis, assumptions and methodology used by the third party to prepare the fair value determination and the OTTI evaluation. Management reviews the qualifications of the third party and believes they are qualified to provide the analysis and pricing determinations. Quarterly, management reviews the third party’s detailed assumptions and analyzes its projected discounted present value results for reasonableness and consistency with the trend of prior projections. Annually, management performs stress tests of the assumptions used in the third party models and performs back tests of the assumptions and prepayment projections to validate the impairment model results. As a result of its due diligence process, management believes that the fair value presented and the OTTI recognized are appropriate. A total of $3.2 million in impairment losses were realized during the time period 2009 through 2011 on the CDO portfolio remaining at December 31, 2017. Due to the prior credit impairment, the securities in this portfolio have continued to be evaluated to determine whether any additional OTTI has occurred. Based on management’s review of the third-party evaluations, management believes that there were no material differences in the valuations between December 31, 2017 and December 31, 2016.

The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued. Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio. Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.

Derivative financial instruments (Cash flow hedge) – The Corporation’s open derivative positions are interest rate swap agreements. Those classified as Level 2 open derivative positions are valued using externally developed pricing models based on observable market inputs provided by a third party and validated by management. The Corporation has considered counterparty credit risk in the valuation of its interest rate swap assets.

Impaired loans – Loans included in the table below are those that are considered impaired with a specific allocation based upon the guidance of the loan impairment subsection of the Receivables Topic, ASC Section 310-10-35, under which the Corporation has measured impairment generally based on the fair value of the loan’s collateral. Fair value consists of the loan balance less its valuation allowance and is generally determined based on independent third-party appraisals of the collateral 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.

Other real estate owned – Fair value of other real estate owned was based on independent third-party appraisals of the properties. These values were determined based on the sales prices of similar properties in the approximate geographic area. These assets are included as Level 3 fair values based upon the lowest level of input that is significant to the fair value measurements.

For Level 3 assets and liabilities measured at fair value on a recurring and non-recurring basis as of December 31, 2017 and 2016, the significant unobservable inputs used in the fair value measurements were as follows:


(in thousands)		Fair Value at December 31, 2017	Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Value
Recurring:

Investment Securities – available for sale - CDO	$	14,920	Discounted Cash Flow	Discount Rate	Range of Libor+ 4.5% to 5.5%

Non-recurring:

Impaired Loans	$	2,507	Market Comparable Properties	Marketability Discount	10.0% to 15.0% (1) (weighted avg 10.9%)

OREO	$	1,841	Market Comparable Properties	Marketability Discount	10.0% to 15.0% (1) (weighted avg 13.3%)


(in thousands)		Fair Value at December 31, 2016	Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Value
Recurring:

Investment Securities – available for sale - CDO	$	20,254	Discounted Cash Flow	Discount Rate	Range of Libor+ 4.5% to 5.5%

Non-recurring:

Impaired Loans	$	14,537	Market Comparable Properties	Marketability Discount	4.6% to 31.0% (1) (weighted avg 6.5%)

OREO	$	1,201	Market Comparable Properties	Marketability Discount	15%

(1) Range would include discounts taken since appraisal and estimated values

For assets measured at fair value on a recurring and non-recurring basis, the fair value measurements by level within the fair value hierarchy used at December 31, 2017 and 2016 are as follows:



			Fair Value Measurements at
			December 31, 2017 Using
			(In Thousands)
	Assets Measured at		Quoted Prices in Active Markets for Identical Assets	Significant Other Observable Inputs		Significant Unobservable Inputs
Description	12/31/2017		(Level 1)	(Level 2)		(Level 3)
Recurring:
Investment securities available-for-sale:
U.S. government agencies	$	29,256		$	29,256
Commercial mortgage-backed agencies	$	40,891		$	40,891
Collateralized mortgage obligations	$	40,384		$	40,384
Obligations of states and political subdivisions	$	21,019		$	21,019
Collateralized debt obligations	$	14,920				$	14,920
Financial Derivative	$	781		$	781
Non-recurring:
Impaired loans	$	2,507				$	2,507
Other real estate owned	$	1,841				$	1,841


			Fair Value Measurements at
			December 31, 2016 Using
			(In Thousands)
	Assets Measured at		Quoted Prices in Active Markets for Identical Assets	Significant Other Observable Inputs		Significant Unobservable Inputs
Description	12/31/2016		(Level 1)	(Level 2)		(Level 3)
Recurring:
Investment securities available-for-sale:
U.S. government agencies	$	24,253		$	24,253
Commercial mortgage-backed agencies	$	52,222		$	52,222
Collateralized mortgage obligations	$	19,567		$	19,567
Obligations of states and political subdivisions	$	23,704		$	23,704
Collateralized debt obligations	$	20,254				$	20,254
Financial Derivative	$	700		$	700
Non-recurring:
Impaired loans	$	14,537				$	14,537
Other real estate owned	$	1,201				$	1,201

There were no transfers of assets between any of the levels of the fair value hierarchy for the years ended December 31, 2017 or December 31, 2016.

The following tables show a reconciliation of the beginning and ending balances for fair valued assets measured using Level 3 significant unobservable inputs for the years ended December 31, 2017 and 2016:



		Fair Value Measurements Using Significant
		Unobservable Inputs
		(Level 3)
		(In Thousands)
	Investment Securities Available for Sale
Beginning balance January 1, 2017	$	20,254
Total gains/(losses) realized/unrealized:
Included in earnings		0
Calls/maturities of investments		(5,810)
Included in other comprehensive income		476
Ending balance December 31, 2017	$	14,920

The amount of total gains or losses for the period
included in earnings attributable to the change in
realized/unrealized gains or losses related to assets
still held at the reporting date	$	0


		Fair Value Measurements Using Significant
		Unobservable Inputs
		(Level 3)
		(In Thousands)
	Investment Securities Available for Sale		Cash Flow Hedge
Beginning balance January 1, 2016	$	22,211	$	(66)
Total gains/(losses) realized/unrealized:
Included in earnings		0		0
Included in other comprehensive loss		(1,957)		66
Ending balance December 31, 2016	$	20,254	$	0

The amount of total gains or losses for the period
included in earnings attributable to the change in
realized/unrealized gains or losses related to assets
still held at the reporting date	$	0	$	0

Gains and losses (realized and unrealized) included in earnings for the periods above are reported in the Consolidated Statement of Income in other operating income.

The fair values disclosed may vary significantly between institutions based on the estimates and assumptions used in the various valuation methodologies. The derived fair values are subjective in nature and involve uncertainties and significant judgment. Therefore, they cannot be determined with precision. Changes in the assumptions could significantly impact the derived estimates of fair value. Disclosure of non-financial assets such as buildings as well as certain financial instruments such as leases is not required. Accordingly, the aggregate fair values presented do not represent the underlying value of the Corporation.

We use the following methods and assumptions in estimating fair value disclosures for financial instruments:

Cash and due from banks: The carrying amounts as reported in the statement of financial condition for cash and due from banks approximate their fair values.

Interest bearing deposits in banks: The carrying amount of interest bearing deposits approximates their fair values.

Restricted investment in Bank stock: The carrying value of stock issued by the FHLB of Atlanta, ACBB and CBB approximates fair value based on the redemption provisions of the stock.

Loans (excluding impaired loans with specific loss allowances): For variable-rate loans that reprice frequently or “in one year or less”, and with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed-rate loans that do not reprice frequently are estimated using a discounted cash flow calculation that applies current market interest rates being offered on the various loan products.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, savings, and certain types of money market accounts, etc.) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on the various certificates of deposit to the cash flow stream.

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

Borrowed funds: The fair value of the Bank’s FHLB borrowings and First United Corporation’s TPS Debentures is calculated based on the discounted value of contractual cash flows, using rates currently existing for borrowings with similar remaining maturities. The carrying amounts of federal funds purchased and securities sold under agreements to repurchase approximate their fair values.

Accrued interest: The carrying amount of accrued interest receivable and payable approximates their fair values.

Off-balance-sheet financial instruments: In the normal course of business, the Bank makes commitments to extend credit and issues standby letters of credit. The Bank expects most of these commitments to expire without being drawn upon; therefore, the commitment amounts do not necessarily represent future cash requirements. Due to the uncertainty of cash flows and difficulty in the predicting the timing of such cash flows, fair values were not estimated for these instruments.

The following table presents fair value information about financial instruments, whether or not recognized in the statement of financial condition, for which it is practicable to estimate that value. The actual carrying amounts and estimated fair values of the Corporation’s financial instruments that are included in the statement of financial condition are as follows:



	December 31, 2017					Fair Value Measurements
					Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(in thousands)	Carrying Amount		Fair Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and due from banks	$	82,273	$	82,273	$	82,273
Interest bearing deposits in banks		1,479		1,479		1,479
Investment securities - AFS		146,470		146,470			$	131,550	$	14,920
Investment securities - HTM		93,632		95,346				86,836		8,510
Restricted Bank stock		5,204		5,204				5,204
Loans, net		882,546		883,936						883,936
Financial derivative		781		781				781
Accrued interest receivable		3,814		3,814				3,814

Financial Liabilities:
Deposits – non-maturity		805,263		805,263				805,263
Deposits – time deposits		234,127		235,489				235,489
Short-term borrowed funds		48,845		48,845				48,845
Long-term borrowed funds		120,929		123,906				123,906
Accrued interest payable		453		453				453
Off balance sheet financial instruments		0		0		0


	December 31, 2016					Fair Value Measurements
						Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
(In thousands)	Carrying Amount		Fair Value			(Level 1)		(Level 2)		(Level 3)
Financial Assets:
Cash and due from banks	$	60,707	$	60,707	$	60,707
Interest bearing deposits in banks		2,603		2,603		2,603
Investment securities - AFS		140,000		140,000			$	119,746	$	20,254
Investment securities - HTM		97,169		97,981				89,031		8,950
Restricted Bank stock		5,209		5,209				5,209
Loans, net		882,008		886,712						886,712
Financial derivative		700		700				700
Accrued interest receivable		3,862		3,862				3,862

Financial Liabilities:
Deposits – non-maturity		773,119		773,119				773,119
Deposits – time deposits		241,110		245,762				245,762
Short-term borrowed funds		36,000		36,000				36,000
Long-term borrowed funds		131,737		133,397				133,397
Accrued interest payable		380		380				380
Off balance sheet financial instruments		0		0		0